Financial Industry Recovery Center

Federal Reserve Raises Discount Rate

Hunton & Williams LLP — Thu, 18 Feb 2010 18:23:44 -0500

The Federal Reserve Board announced today that the primary credit rate, the interest rate it charges on emergency loans to banks, would be raised by one-quarter percentage point from .5 percent to .75 effective Friday, February 19, 2010. Also known as the discount rate, the primary credit rate had been at .5 percent since December 2008.

Click here for further details from the Federal Reserve Board.

TARP Initiative for Small Businesses Detailed

Hunton & Williams LLP — Wed, 03 Feb 2010 16:54:07 -0500

Today the Obama Administration detailed revised terms for a program designed to foster lending to small businesses in underserved communities through the Troubled Asset Relief Program (TARP). Originally announced in October 2009, the program provided lower-cost capital to Community Development Financial Institutions (CDFIs), such as community banks, thrifts and credit unions, which then provide loans to small businesses in underserved communities. The newly announced rules increase the amount of capital available to CDFIs, from 2 percent of risk weighted assets to 5 percent, and expands the number of institutions who qualify as a CDFI.

Click here for the Department of Treasury's key terms and enhancements to the TARP initiative.

The Years 2009-2011: A Once-in-a-Generation Opportunity

Hunton & Williams LLP — Fri, 22 Jan 2010 14:15:06 -0500

In 2009, 140 banks failed. Yet, the number of banks with nonperforming assets that exceed 5 percent of total assets has continued to climb and now exceeds 1,000. Even the banks that are not deemed to be in a “troubled” condition are suffering the effects of the economic conditions. With commercial real estate values expected to continue to deteriorate in most markets through 2010, the incentive for many financial institutions is to “hunker down” to get through to the other side when economic conditions are expected to improve.

This approach may very well be a tremendous mistake. Such institutions could miss out on a once-in-a-generation buying opportunity. Moreover, once conditions do improve, they might face a form of survivor’s hell.

As we saw in the last economic collapse coming out of the savings and loan crisis, those institutions that were aggressive buyers were better positioned to compete in the improved environment. Last time, some of the biggest banks in the country, as well as a host of regional competitors, gained tremendous market share at nominal cost, thereby increasing shareholder value and positioning themselves to expand further once circumstances warranted it.

Circumstances may not be different this time around. Financial institutions are buying failed banks, branches and other assets of stressed sellers and expanding organically. Moreover, it appears that customer loyalty may improve after this collapse, translating into higher net interest margins (“NIMs”). These buyers will be well positioned for the recovery. Thus, there is risk to standing on a pat hand. Accordingly, I have set forth below certain of the types of transactions that financial institutions now should be considering.

Trust-preferred Buybacks
We have assisted a number of our clients with repurchases of their trust-preferred securities (“TRUPS”). A TRUPS buyback can free an organization from its debt service obligation or reduce it — an important opportunity if we are entering an inflationary environment.

After 2001, TRUPS were mainly issued by community and regional banking organizations in pools. Pools were either managed or static. In a managed pool, the collateral manager has some discretion to replace the existing TRUPS issued by a bank holding company with another security or with cash. A TRUPS repurchase involving a managed pool is a negotiation with the collateral manager and the investors in those pools. Consequently, it is important to understand the role, responsibilities and potential conflicts of the collateral manager in the repurchase process and take steps through agreements to address such issues.

In contrast to a managed pool, in a static pool the assets in the pool were not intended to change. There is no collateral manager for such a pool. The trustee of the pool has no investment discretion.

In connection with a static pool, the objective of the issuer is to be able to communicate directly with the note holders (the investors in the pools). The trustee will seek to avoid disclosing the identity of the note holders. Accordingly, the issuer must push the trustee to facilitate the issuer’s tender to the note holders.

In fact, CIB Marine Bancshares, Inc., in Pewaukee, Wisconsin (“CIB Marine”), filed for bankruptcy under Chapter 11 in an effort to bring the note holders to the table in connection with a proposed swap of preferred stock for TRUPS. The preferred stock was convertible to common shares. The purpose of the offer was to make CIB Marine more attractive to buyers. Our experience is that such offers work best when there is a viable recapitalization plan already in place.

As can be imagined from the discussions set forth above, it is much easier to work through the process with a managed pool than with a static pool. The process can be considerably quicker with a managed pool. Nonetheless, we have had success with both types of pools. In fact, we believe that we are the only firm to have succeeded in three offers involving static pools.

A TRUPS buyback also requires approval by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Accordingly, the offer must be well structured to convince the Federal Reserve that use of corporate resources to buy back the TRUPS is consistent with the Federal Reserve’s Source-of-Strength Policy Statement.

M&A
There were very few bank M&A transactions in 2009. The approximately $2 billion of aggregate deal size paled in comparison to prior years. I do not expect the environment to change much this coming year. Potential acquirers are deeply concerned regarding the asset quality of potential sellers. In light of the structure of FDIC deals, such transactions will significantly reduce the volume of M&A transactions that do not involve government assistance. Sheila Bair anticipates the volume of bank failures to start to come back down sometime in 2011. If she is correct, M&A activity without government assistance is likely to continue to be depressed until then.

I do expect an increase in merger-of-equals (“MOE”) transactions. The acquisition by $4.3 billion-asset Chemical Financial Corp., of Midland, Michigan (“Chemical”), of $840 million-asset O.A.K. Financial Corp., (the parent for Byron Bank) of Byron, Michigan (“O.A.K.”), epitomizes these types of transactions. In the merger transaction, shareholders of O.A.K. will receive common stock of Chemical equal to 1.08 times O.A.K.’s tangible book value. The transaction will increase Chemical’s presence in the Michigan oasis community of Grand Rapids, Michigan, from 14 to 31 locations. MOE transactions can provide significant benefits in the current market. Such transactions allow participants to grow without reducing capital levels. The combination provides an opportunity to enhance earnings from cost savings as well as a larger platform upon which to enhance the sophistication of customer services offered.

A MOE is a transaction between two or more somewhat similar-sized banks where the banks combine with each other, rather than one acquiring the other(s). These transactions were relatively common before bank pricing exploded. Now that we are in a period of reduced premiums from sales, MOEs may become a relatively attractive way to grow the platform and earnings by forming a strategic alliance between two or more community banks.

Some of the more common features of a MOE transaction are:

somewhat similar asset size among the banking companies involved (but this need not be the case);
neither bank initially dominates the combined senior management group;
the form of consideration is primarily common stock;
no “premium” price is paid (a MOE is less an acquisition/sale than a financial combination); and
the negotiating atmosphere is usually friendly.

In such transactions, the nonfinancial (“social”) issues are extremely important. Accordingly, serious discussions/negotiations should be held, early on, to resolve the many social barriers to consummating a transaction of this sort. Compromises will absolutely be necessary because neither shareholder group will own 100 percent of the combined company, one shareholder group will likely become the “minority” shareholders, and decision making at the board and senior management levels will be shared. Many prospective MOE transactions are never consummated due to unresolvable social problems.

MOE transactions involve some important distinctions from typical mergers. First, each party will perform a “due diligence” investigation of its prospective merger partner.

Recognizing that two or more similar-sized banks are involved, the opportunity to recognize significant merger savings enhances the importance of developing a specific integration plan early on. Key people should have designated responsibilities and an appropriate time schedule should be set.

MOE transactions provide the following advantages. They

conserve equity capital and enhance debt capacity;
increase access to alternative forms of financing;
increase the marketability/liquidity of shares by increasing the number of shareholders, and possibly enhancing the market price per share;
improve senior management depth;
limit earnings and equity per share dilution as compared to an acquisition at a competitive purchase price level (no “premium” price is paid by either party);
achieve economics of scale/merger from savings usually available through reduction in duplicate operations/staffs, thereby materially enhancing combined shareholder value (without having to “sell out”);
allow the diversification of trade area economic/customer base concentrations; and provide for a combination of the financial and market strengths of one merger partner with those of the other merger partner.

MOE transactions have the following disadvantages:

They are a difficult form of transaction to close, typically due to problems in resolving the many social issues.
The merger partners must be willing to dilute existing shareholder ownership percentages.
The merger partners must be willing to share decision-making responsibility/authority at the senior management level and at the combined board of directors.
Significant organizational, operational and producer integration of the merger partners, while very common in this type of transaction, is never easy. (People frequently do not embrace significant change willingly.)
The corporate cultures of the merger partners may be substantially different, requiring a major effort to re-orient the combined company in a unified direction.
A significant layoff of the combined company’s staff may be necessary in order to achieve the potential shareholder value enhancements available.

The ultimate financial success of a MOE transaction will be determined by how well the combined managements and boards from both merger partners work together to realize the financial benefits that are almost always present in a transaction of this type. The development and implementation of a sound operational integration plan is a must. However, if the important social issues are not agreed upon early, it is highly unlikely that a transaction will ultimately be consummated.

Subchapter S
A Subchapter S corporation that sells assets that have built-in gains must pay taxes on those assets if the built-in gain existed when the financial institution made its Subchapter S election. If, however, the financial institution has been an S corporation for at least 10 years, this built-in gains tax goes away.

For Subchapter S corporations, the elimination of the built-in gains tax provides a potential win-win for the buyer and the seller. In the event the parties elected for the transaction are to be taxed as a sale of assets (the stock is still being sold, but it is treated as an asset sale), then the buyer would be able to deduct any premium paid over the next 15 years. To the extent the premium is significant, then there is an opportunity for the buyer and seller to share in some proportion of the tax benefit.

For the remainder of 2009 and 2010, the time frame triggering a built-in gains tax has been reduced to seven years. Accordingly, any sale of S corporation assets that have been held more than seven years, including the sale of the entire company in an asset sale, will not trigger a built-in gains tax. Starting in 2011, the time frame for a built-in gains tax goes back up to 10 years.

Problem Bank Acquisitions
As discussed below, failed bank opportunities may not be available for many financial institutions because of their size. Moreover, the franchise value of a failed bank has generally been significantly eroded by the time the FDIC liquidates it. Even in the best circumstances, to acquire a failed bank requires winning an auction process. In addition, the FDIC retains the failed bank’s tax attributes. Accordingly, an acquisition of a bank that still is solvent may be preferable to taking the chances of winning the bidding for a franchise that has been decimated.

Unquestionably, there are significant challenges to such acquisitions. There is no substitute for due diligence. If the acquirer concludes that the target truly is solvent, structural tools can be put in place to assist in protecting the acquirer from the target’s asset issues identified during diligence. For instance, in Chemical’s acquisition of O.A.K. discussed above, the purchase price to O.A.K. would decline $1.50 for every $1.00 in loan losses O.A.K. suffers above $10 million.

The acquisition by Tower Bancorp, Inc. (Harrisburg, Pennsylvania) of First Chester County Corp. (also in PA) (“First Chester”) also includes deal protection that provides for the deal value to decline based on charge-offs.

First Chester, a $1.3 billion-asset bank, experienced significant credit quality deterioration in 2009. Specifically, nonperforming assets increased to 3.7 percent of total assets, or $35.5 million, at September 30, 2009. The additional 30- to 89-day past-due loans were approximately $10 million.

Under the terms of the transaction, if delinquencies are less than $55 million, the purchase price will not change. If, however, delinquencies exceed that level, First Chester shareholders would receive a reduced amount.

There are other tools that are available for cash deals as well as stock deals. For instance, a portion of the purchase price can be placed in escrow to protect the acquirer from asset losses. Similarly, a portion of the merger consideration can be paid in the form of a promissory note, which would be written down and could even disappear based upon asset performance.

Such transactions involve a fair degree of negotiation around management and liquidation of assets as well as the determination of when a loss has occurred. Nonetheless, such structures are able to provide significant insurance against further asset deterioration.

Failed Bank Purchases
The current economic cycle and the regulatory response to asset quality issues will result in a significant number of failures. My own expectation is that these financial institution failures are likely to be closer to a thousand than to five hundred. At year-end 2009, financial institutions with assets below a billion dollars and between one billion and ten billion were experiencing higher percentages of asset quality issues than their bigger bank brethren. At September 30, 2009, 489 financial institutions had Texas¹ ratios of 80 percent or higher. By any measurement, the volume of financial information failures will be significant.

In such transactions, the FDIC offers loss sharing. The FDIC provides a “stated threshold” on every transaction. The bidders are provided with the specific amount of the stated threshold a week to 10 days before the bids are due. Up to the amount of the stated threshold, all losses, net of recoveries, and reimbursable expenses are shared 80 percent to the FDIC and 20 percent to the assuming bank. Beyond the stated threshold, the FDIC absorbs 95 percent of such losses and expenses.

Currently, it is typical that a winning bidder will bid a discount on the transaction, meaning that the FDIC would pay it for engaging in the transaction. The discount can be expected to cover anticipated loan losses among other costs to the assuming bank. In most transactions, the winning bidder has booked a one-time gain on a bargain sale, which is a taxable one-time profit from engaging in the transaction.

There are other statutory and contractual protections to winning bidders. For instance, the FDIC will provide indemnification in certain circumstances. In addition, winning bidders have the ability to reprice the deposits of the failed bank. The assuming bank also has the option to reject the contracts of the failed bank.

Currently, financial institutions that are CAMELS 1- and 2-rated are contacted for failing institutions in their general geographic area, but there are size limitations for prospective acquisitions. Financial institutions considering failed-bank acquisitions should develop prospective take-down/management and capital plans for failed-bank transactions. The board should update its strategic plan to identify the size and geographic scope of potential acquisitions and the desired markets. Management should obtain from their regulators preclearance to bid on institutions in those markets. In light of the short due diligence period and unique structure and terms of the failed-bank transaction and the purchase and assumption agreement, considerable preparation and even a dress rehearsal for a desired transaction is appropriate.

We have been involved in the first shelf charter for an investor group, the first shelf charter granted to an existing holding company and more than 5 percent of the failed-bank transactions since the beginning of 2009, including representation of the assuming bank in four acquisitions of failed banks with over a billion dollars in assets. In addition, we have been involved in capital raises timed to close immediately prior to a failed-bank transaction. Accordingly, we would be happy to provide assistance in answering questions for financial institutions considering the pros and cons of failed-bank acquisitions.

Branch Purchases
As discussed previously, a significant number of regional financial institutions are struggling. Many times, such institutions will be subject to formal administrative action requiring them to achieve certain minimum capital ratios on a short deadline or suffer regulatory sanction. For those institutions, a sale of assets can help meet required capital ratios by reducing the denominator, while increasing the numerator.

Specifically, although there have been a couple of branch sales with no premium, they have proven to be the exception. In most branch sales, the purchaser pays a premium that is typically expressed as a percentage of deposits for the assets and liabilities associated with one or more branches. Because the selling institution is often in a net loss carry-forward position, the full amount of the purchase price increases the seller’s shareholders’ equity.

Conversely, the effect of a branch sale is to shrink the seller’s assets. Oftentimes, the seller will sell the loans associated with those branches as well. It is increasingly common to see the seller grant the acquirer a “cherry pick” right with regard to the loans to be acquired. The effect of such a sale is to reduce both total and risk-based assets. Thus, the cumulative effect of an asset sale is to increase the selling financial institution’s capital ratios.
For the acquirer, such a transaction provides the opportunity to grow the platform by adding relatively low-risk assets. Such a branch purchase may be immediately accretive.

Conclusion
Financial institutions should consider how to position themselves to take advantage of the opportunities presented in the current economic environment. Those who do so will have a once-in-a-generation opportunity to expand their banking platform and enhance shareholder value. Such opportunities may be truly transformative and, thereby, position the financial institution for the next turn of the economic dial.

¹ The Texas ratio is nonperforming assets divided by the sum of shareholders’ equity and the allowance for loan losses.

By: Peter G. Weinstock

Swap Termination and the Subordination of Termination Payments in the Lehman Bankruptcy

Hunton & Williams LLP — Tue, 22 Dec 2009 16:12:43 -0500

Lehman Brothers Holdings Inc.’s September 15, 2008 bankruptcy was an event of default under thousands of derivatives contracts to which a Lehman entity was a party and for which Lehman Brothers Holdings was the guarantor. This default entitled the vast majority of Lehman’s counterparties to terminate these contracts, and almost all were terminated. The Lehman bankruptcy court will soon address a number of issues related to the termination of these contracts, including the enforceability of “flip clauses” subordinating amounts payable to Lehman on the termination of credit default swaps backing synthetic collateralized debt obligations (CDOs).

CONTINUE READING...

FDIC Asset Sale Safe Harbor Proposal and Regulatory Capital Rule

Hunton & Williams LLP — Tue, 22 Dec 2009 10:50:46 -0500

On December 15, 2009 FDIC undertook a couple of rulemaking matters of importance to securitizations by regulated institutions.

1. FDIC Safe Harbor for Sales of Assets in Securitizations. In 2000, the FDIC adopted a legal isolation safe harbor providing that the FDIC would not use its contract repudiation powers to “unwind” or otherwise challenge the integrity of securitizations satisfying the criteria for treatment as sales under generally accepted accounting principles in the event of the insolvency or receivership of the sponsoring bank. Earlier this year, the Financial Standards Accounting Board adopted revised criteria for sales under GAAP (FAS 166 and 167), under which most securitizations would not qualify as sales for GAAP accounting purposes. If the FDIC were not to respect the integrity of such securitizations, the rating agencies would not be able to provide the requisite ratings that make securitizations by banks viable.

As a remedy for this, the FDIC issued an interim rule (effective through March 31, 2010) protecting existing securitizations that comply with the existing safe harbor until a new safe harbor is put in place. On December 15, 2009, the FDIC issued an advance notice of proposed rulemaking (“ANPR”) regarding a new safe harbor available to insured institutions selling assets in connection with securitizations. An ANPR is used to elicit comments with in 45 days on the broad outlines of, or issues to be addressed in, a proposed rule and to provide a regulator with background information on the area of the proposed rule.

View the FDIC’s ANPR.

In connection with the FDIC’s ANPR, the Comptroller of the Currency, John C. Dugan, issued a press release on December 15, 2009 describing his views and expressing some concerns with some of the proposals described in the FDIC’s ANPR.

View Comptroller Dugan’s press release.

The FDIC’s ANPR contemplates that future securitizations by insured institutions would have to satisfy certain conditions in order for those securitizations to be respected by the FDIC in an insolvency or receivership of the insured institution. Furthermore, the FDIC’s ANPR proposes that securitizations backed by residential mortgages meet certain additional requirements. In order to be respected, the FDIC’s ANPR inquires whether securitizations should include the following features, among others:

The bank must maintain 5 percent credit exposure on the assets in the transaction (on vertical strip basis or by retaining a representative sample of the assets).
If the transaction is not registered under the Securities Act of 1933, the transaction must nevertheless satisfy all Reg AB requirements.
The transaction may not be a synthetic securitization.
If the assets are residential mortgages, the FDIC’s ANPR inquires whether the following additional requirements should apply:
- the loans must be seasoned at least 12 months;
- the sponsoring bank must affirm compliance with all origination legal requirements and agency requirements, and the loans must be underwritten at a fully indexed rate based upon documented income;
- no more than 80 percent of the fees to the lender, the sponsor, the rating agencies and the underwriters can be paid at closing and the remaining fees must be paid over a five-year period, based upon asset performance;
- no external credit enhancement may be used at the pool level; however temporary liquidity may be provided and individual assets may be guaranteed or insured;
- the servicer must have a duty to mitigate losses on a net present value basis, for the benefit of all investors and not any particular class; the servicer must have the ability to modify loans to mitigate losses; and servicing fees must provide an incentive for the servicer to mitigate losses;
- in the absence of reimbursement or financing facilities, advancing on delinquent loans may be required for only three months; and
  the transaction may have no more than six credit tranches and cannot include any sub-tranches; however, the most senior tranche may include sequential pay sub-tranches.

2. Regulatory Capital. The FDIC also issued a final rule on regulatory capital matters relating to the implementation of FAS 166 and FAS 167. The other federal banking regulators, however, have not joined the FDIC on this final rule, so further changes may yet be made.

View the FDIC’s final rule.

FAS 166 and FAS 167 have the effect of causing many previously off-balance sheet assets and any future asset that does not satisfy the requirements for off-balance sheet treatment under FAS 166 or that is consolidated under FAS 167 to be either brought back or remain on balance sheet, with a resulting effect on a bank’s risk-based capital requirements. To address this, the FDIC’s final rule provides for (a) a two-quarter delay, at the option of the bank, for the implementation by a bank in recognizing prior existing assets brought or remaining on balance sheet by FAS 166 and FAS 167 and (b) a two-quarter phase-in (following the optional two-quarter delay in implementation) of capital resulting from the assets being on balance sheet. There will be no capital relief where the bank provided implied or voluntary support and no relief from leverage ratio requirements.

The FDIC’s final rule also provides that asset-backed commercial paper conduits will be on balance sheet, with no exemptions or other relief available. It also rejects the industry’s interpretation of Basel II’s internal assessment approach that this approach could be applied to conduit exposures by saying that such approach is available only to off-balance sheet ABCP conduits and exposures.

House of Representatives Passes Finance Rules Overhaul Bill

Hunton & Williams LLP — Fri, 11 Dec 2009 16:20:01 -0500

The House of Representatives passed the "The Wall Street Reform and Consumer Protection Act of 2009" (HR 4173) today in a vote of 223-202. The legislation creates the Consumer Financial Protection Agency, a council of regulators tasked with identifying companies that the federal government deems as so interconnected with other large companies that its failure would endanger the U.S. economy as whole, and addresses other financial areas like derivatives, hedge funds, lending practices, and dissolution of failing companies. The Senate is currently drafting its own bill on the same subject matter.

Click here for the House Financial Services Committee's press release, click here for HR 4173, click here for the bill's summary, and click here for the Treasury Department's press release.

Business Tax Provisions of the Worker, Homeownership, and Business Assistance Act of 2009

Hunton & Williams LLP — Wed, 18 Nov 2009 16:41:43 -0500

On November 6, 2009, President Barack Obama signed into law the Worker, Homeownership, and Business Assistance Act of 2009 (the “Act”). The significant tax changes applicable to businesses under the Act are summarized below.¹

Net Operating Loss Carryback. A net operating loss (“NOL”) for a taxable year is the excess of business deductions over the business’ gross income for that taxable year. Under current law, a taxpayer may “carry back” an NOL to offset taxable income of the two tax years immediately prior to the tax year in which the NOL is incurred and may then carry forward any remaining portion of the NOL up to 20 years to offset taxable income in future tax years. Current law also provides that “eligible small businesses” may elect to carry back an “applicable 2008 NOL” for three, four or five years. An “eligible small business” is generally defined as a taxpayer with annual gross receipts of $15,000,000 or less in the tax year in which the applicable 2008 NOL arose. For purposes of the election, an “applicable 2008 NOL” is defined as the taxpayer’s NOL for any tax year ending in 2008, or, at the taxpayer’s election, any tax year beginning in 2008. The election to extend the carryback period is irrevocable and can be made only with respect to one tax year.

The Act extends the availability of the election to carry back “an applicable NOL” up to five years to most taxpayers, excluding certain taxpayers discussed below. For these purposes “an applicable NOL” is defined as the taxpayer’s NOL for any tax year ending after December 31, 2007, and beginning before January 1, 2010. Generally, an election may be made for only one year. However, an “eligible small business” that made or makes an election under the Code as in effect prior to November 6, 2009 (i.e., the enactment date of the Act) may make an election for two tax years instead of one year.

The election under the Act must be made by the due date (including any extensions) for filing the taxpayer’s tax return for the taxpayer’s last taxable year beginning in 2009. Any such election, once made, is irrevocable. In addition, the Act provides for certain transition rules with respect to NOLs for a taxable year ending before the date of enactment of the Act. Any election made by the taxpayer to waive the carryback period under Code Section 170(b)(3) may be revoked at any time before the due date (including any extensions) for the taxpayer’s last taxable year beginning in 2009 and any application under Code Section 6411(a) for a tentative carryback refund with respect to an NOL for a tax year ending before the date of enactment of the Act will be treated as timely filed if filed before the due date for the taxpayer’s 2009 tax return (including any extensions).

In addition, the Act provides certain limitations on the amount of NOLs that may be carried back to the fifth tax year. A taxpayer may not use an applicable NOL to offset more than 50% of the taxpayer’s taxable income for the fifth preceding tax year (not taking into account any NOLs for the fifth preceding tax year or any subsequent year). The amount of NOLs carried back to years two, three and four is adjusted to take into account such 50% limitation. However, the 50% limitation does not apply to the applicable 2008 NOL of an eligible small business if an election is made under law in effect prior to the Act, even if such election is made after the date of enactment of the Act.

Certain taxpayers are ineligible to elect an extended carryback period including (1) any taxpayer in which the federal government has acquired an equity interest or any warrant or right to acquire an equity interest in the taxpayer under the Emergency Economic Stabilization Act of 2008 (the “EESA”); (2) a taxpayer that receives funds from the federal government after the enactment date of the Act in exchange for an equity interest or a right to acquire such equity interest in the taxpayer under a program established under the EESA, unless the taxpayer is a financial institution as defined in the EESA and the funds are used pursuant to a program established by the Secretary of the Treasury for the purpose of increasing the availability of credit to small businesses; (3) the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac); and (4) any taxpayer who is a member of the same affiliated group as a taxpayer described in this paragraph.

In conclusion, C corporations (including recently electing S corporations) with NOLs from C corporation tax years ending after December 31, 2007 and beginning before January 1, 2010 may want to consider utilizing the election procedure provided for in the Act and extend the carryback period for any applicable NOLs for up to five years.

Other Provisions Applicable to Businesses

Suspension of 90% NOL Limitation for Alternative Minimum Tax Purposes. Under current law, for purposes of the alternative minimum tax (“AMT”), a taxpayer’s NOL deduction cannot reduce the alternative taxable income of the taxpayer by more than 90%. The Act suspends this 90% limitation for tax years ending after 2002 in the case of an “applicable NOL” for which the extended carryback period has been elected.

FUTA Surtax. Prior to the Act, the Federal Unemployment Tax Act (“FUTA”) was imposed at a rate of 6.2% (which is comprised of a 6% permanent tax rate and a 0.2% temporary surtax) through 2009 and at a rate of 6% for 2010 and later years. The Act extends the application of the 0.2% FUTA surtax through June of 2011. The 6% rate will apply for the remainder of 2011 and subsequent years.

Estimated Tax Payments for Large Corporations Increased for 2014. Generally, a corporation must make quarterly estimated tax payments with respect to its income tax liability for the taxable year. For a corporation whose taxable year is the calendar year, these estimated tax payments must be made by April 15, June 15, September 15 and December 15. On July 28, 2009, the Corporate Estimated Tax Shift Act of 2009 (“Shift Act”) was signed into law, requiring large corporations (i.e., corporations with assets of not less than $1 billion as of the preceding taxable year) to increase the amount of their quarterly estimated tax payments for July, August or September of 2014 to an amount equal to 100.25% of the amount that would otherwise be due, with the amount of their next quarterly estimated tax payment being reduced accordingly. Under the Act, the quarterly estimated tax payments for such large corporations in July, August or September 2014 under the Shift Act will be increased by an additional 33%. The amount of the next required quarterly estimated payments will be reduced to reflect such increase in the earlier installments.

Increased Penalty for Failure to File Partnership or S Corporation Returns. If a partnership or an S corporation fails to file an annual return, a penalty is imposed in the amount of $89 multiplied by the number of shareholders or partners for each month that the failure continues; however, the penalty may be imposed for only 12 months. Under the Act, the penalty is increased to $195 per partner or shareholder for tax years beginning after December 31, 2009.

¹All Section references are to the Internal Revenue Code of 1986, as amended (the “Code”), unless otherwise indicated.

Federal Reserve Requires Banks to Implement New Overdraft Procedures and Related Disclosures

Hunton & Williams LLP — Mon, 16 Nov 2009 16:09:20 -0500

The Federal Reserve emphasized its newly donned role of the consumer protector on November 12, 2009 when it issued final revisions to Regulation E (the “Final Rule”) that will require many banks to revise their existing procedures for paying and disclosing consumer overdrafts that result from automated teller machine (“ATM”) and one-time debit card transactions. Banks are required to achieve full compliance with the Final Rule by July 1, 2010. For many banks, it is likely that full compliance will involve significant operational and processing changes, as well as the implementation of new procedures and new customer disclosures. These types of changes take time to implement, and so we recommend that banks act immediately to assess their overdraft protection services in light of the Final Rule, in order to determine what changes will be necessary to achieve timely compliance.

Senate Banking Committee Democrats Release Financial Regulatory Overhaul Draft Bill

Hunton & Williams LLP — Tue, 10 Nov 2009 10:16:22 -0500

Today Senate Banking Committee Chairman Christopher Dodd and his Democratic Banking Committee colleagues released draft financial regulatory reform legislation. The new draft legislation comes as the House Financial Services Committee has yet to complete its markup of similar legislation. Today's released legislation outlines a process for the government to determine which financial companies are more stringently regulated, the regulations to be used and the inner workings with a newly created Agency for Financial Stability. Additionally, the legislation sets forth a process for winding down such financial companies. Both the Office of Thrift Supervision and Office of the Comptroller of the Currency would be eliminated under the bill and replaced by a single entity, the Financial Institutions Regulatory Administration.

Click here for the press release, click here for a summary of the draft legislation and click here for the actual draft legislation.

New CRE Loan Workout Rules Provide Relief and Pitfalls

Hunton & Williams LLP — Wed, 04 Nov 2009 12:36:36 -0500

On October 30, 2009, all of the federal regulatory agencies issued a new policy statement on commercial real estate (“CRE”) loan workouts. The policy statement does offer opportunities for financial institutions (“FI”) to reduce the amount of charge-offs on CRE loans, return restructured loans to a performing status faster and generally work with customers on mutually beneficial workouts. Nonetheless, the policy statement does present challenges before FIs can achieve such results, especially for those management teams seeking to “kick the can down the road” to await better days. Notably, however, the policy statement does not change regulatory reporting guidelines or the accounting requirements under generally accepted accounting principles (“GAAP”).

Treasury Dept. and House Financial Services Committee Release Draft Systemic Risk Bill

Hunton & Williams LLP — Tue, 27 Oct 2009 10:16:29 -0500

Today the Treasury Department and the House Financial Services Committee jointly released draft legislation addressing systemic risk. The new draft legislation comes two days before the House Financial Services Committee is scheduled to hold a hearing on systemic risk, Thursday, October 29, 2009. Today's revised legislation outlines a process for the government to determined which financial companies are more stringently regulated, what regulations will be used and how they will work. Additionally, it sets forth a process for winding down such companies.

Click here for a summary of the draft legislation and press release, and click here for the actual draft legislation.

TARP Executive Compensation Special Master Issues First Rulings

Hunton & Williams LLP — Thu, 22 Oct 2009 11:38:14 -0500

Special Master for TARP Executive Compensation Kenneth R. Feinberg announced his compensation package determinations for top executives at firms receiving significant TARP assistance. The announcement impacts the five most senior executive officers and the next twenty most highly compensated employees at each of the following: American International Group, Inc. (AIG); Citigroup Inc.; Bank of America Corporation; Chrysler Group, LLC; General Motors Company; General Motors Acceptance Corporation Financial Services (GMAC) and Chrysler Financial.

Click here for the press release detailing the determinations, and click here for the letters sent by the Treasury Department to each of the firms.

Consumer Financial Protection Agency Bill Passes the House Financial Services Committee

Hunton & Williams LLP — Thu, 22 Oct 2009 10:18:06 -0500

Today the House Financial Services Committee passed legislation to create the Consumer Financial Protection Agency. Although the legislation has yet to pass the full House and Senate, the current bill would make the new agency responsible for rulemaking, examination and enforcement of financial institutions that provide consumers with financial products and services. Furthermore, the Federal Reserve's rulemaking authority under current consumer banking laws would be transferred to the new agency.

Click here for the House Financial Service Committee's press release, and click here for the bill's summary.

House Agriculture Committee Approves Derivatives Regulation

Hunton & Williams LLP — Wed, 21 Oct 2009 09:36:01 -0500

The House Agriculture Committee approved today legislation to regulate over-the-counter ("OTC") derivatives. Today's approval amends the bill passed out of the House Financial Services Committee on October 15, 2009. According to today's press release, "the bill institutes a clearing and trading requirement for all OTC swap transactions between dealers and large market participants that are accepted by a clearinghouse. Additionally, non-cleared swaps must be reported, with major participants and dealers adhering to strengthened capital and margin requirements. The bill exempts commercial end users who use derivatives markets to hedge their price risk from the clearing requirement."

Click here for the House Agriculture Committee's press release, and click here for the legislative text.

House Financial Services Committee Approves Derivatives Regulation

Hunton & Williams LLP — Thu, 15 Oct 2009 10:37:42 -0500

The House Financial Services Committee approved today legislation to regulate over-the-counter ("OTC") derivatives. Included in OTC derivatives are swaps which, under the legislation, will now mostly be traded on exchanges and certain swap participants will be required to register with the applicable governing commission. Additionally, the legislation lays out a parallel track regulatory framework with joint rulemaking authority residing in the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). Should the SEC and CFTC be unable to issue joint rules within 180 days, the Treasury Department will have the ability to issue final rules.

For more details click here for the House Financial Services Committee's press release, and click here for the mark-up and recorded vote tally.

Over-The-Counter Derivatives Regulation Draft Bill Released

Hunton & Williams LLP — Fri, 02 Oct 2009 18:25:39 -0500

House Financial Services Committee Chairman Barney Frank released a discussion draft of legislation to regulate over-the-counter ("OTC") derivatives Friday on Capitol Hill. The draft is being circulated in anticipation of the Committee's hearing scheduled for Wednesday, October 7, 2009 on OTC derivatives.

Click here for the press release, and click here for the full text of the discussion draft of the bill.

Newly Proposed Financial Regulatory Reform Legislation Would Broaden SEC Powers, Create Federal Insurance Office

Hunton & Williams LLP — Thu, 01 Oct 2009 15:45:45 -0500

Three proposed pieces of financial regulatory reform legislation released today would collectively increase the U.S. Securities and Exchange Commission's (SEC) power and budget, require private advisers to hedge funds to register with the SEC, and create a Federal Insurance Office to assist policy makers in analyzing the insurance industry, according to today's press release by the House Financial Services Committee's Capital Markets Subcommittee Chairman Paul Kanjorski. The draft bills are for each of the following, the Investor Protection Act, the Private Fund Investment Advisers Registration Act, and the Federal Insurance Office Act.

Click here for today's press release outlining each of the proposed bills. Click here for the Investor Protection Act draft bill, click here for the Private Fund Investment Advisers Registration Act draft bill, and click here for the Federal Insurance Office Act draft bill.

FDIC Proposed Rule Would Require Banks to Prepay Quarterly Risk Assessments Through 2012

Hunton & Williams LLP — Mon, 28 Sep 2009 18:31:22 -0500

A rule proposed today by the the Board of Directors of the Federal Deposit Insurance Corporation ("FDIC") would require banks to prepay their estimated quarterly risk-based assessments beginning with the fourth quarter of 2009 through 2012. The prepaid assessments would total approximately $45 billion, according to today's press release. Additionally, the FDIC voted to adopt an increase in the assessment rate starting January 1, 2001 by a uniform three-basis points. Today's proposed rule is designed to bolster the Deposit Insurance Fund.

Click here for today's press release, click here for the FDIC's Notice of Proposed Rulemaking, and click here for the Deposit Insurance Fund Restoration Plan.

Treasury Department Releases Financial Stabilization Status Report

Hunton & Williams LLP — Mon, 14 Sep 2009 18:58:25 -0500

The Treasury Department outlined today the federal government's next steps along the road to financial recovery in a report entitled, "The Next Phase of Government Financial Stabilization and Rehabilitation Policies." The report indicates there are four "key elements" for the government: (i) "exiting from some emergency programs," (ii) "diminishing reliance on federal support," (iii) "from infusing capital to repaying capital," and (iv) the "ongoing role for policy."

Click here for the Treasury Department's press release, and click here for the full report including the executive summary.

The Evolving Landscape for Financial Institutions

Hunton & Williams LLP — Thu, 03 Sep 2009 11:32:34 -0500

This is the fourth client alert that I have written this year dedicated solely to the evolving landscape that banks are confronting. Nowhere is the ground shifting more than in financial institutions’ interaction with regulatory authorities. Several of these issues are discussed below.

Commercial Real Estate
The regulators’ position with regard to commercial real estate lending (“CRE”) has changed dramatically in the past three years. In 2006, the bank regulators issued guidance regarding CRE lending. Specifically, the guidance provided that, in the event a bank’s non-owner-occupied CRE loans approached 300 percent of capital or more, then the financial institution had to ratchet up its underwriting, monitoring and other facets of risk mitigation. Nowhere in the guidelines was there a cap on CRE lending. Even still, the reaction of the banking industry to the guidelines was near pandemonium. Bankers were concerned that the guidelines would be a de facto cap. The bank regulators responded to clarify that the guidelines were merely benchmarks and were not limitations.

How the world has changed! The bank regulatory authorities are absolutely looking at non-owner-occupied CRE of 300 percent as a maximum. The Federal Deposit Insurance Corporation (“FDIC”), in particular, seems determined to wipe out the “scourge” that is CRE lending. A financial institution that is materially over this level is virtually assured some administrative action. The other CRE ratio that is getting significant attention during examinations is the acquisition, development and construction (“ADC”) loan above 100 percent of capital. We have had financial institutions that file quarterly reports reflecting CRE levels above 300 percent or ADC levels above the 100 percent ratio receive phone calls to advise them of accelerated timing of examinations, between-examination “visitations,” information requests and even proposed administrative actions independent of any examination.

Of course CRE and ADC loans by themselves do not indicate violations of law or the existence of unsafe and unsound conditions or practices (the prerequisites for administrative action). Nonetheless, the regulators are drilling down from there to find the support necessary for a corrective action document.

The issues that are often discussed include the following:

Interest reserves. The regulatory authorities believe that interest reserves mask deterioration and asset quality issues. This is the case even if the customer funded the interest reserve to provide credit enhancement.
Interest-only credit. The regulators expect all loans, including ADC loans, to be placed on an amortization schedule. Loans to be repaid from home sales by builders are especially susceptible to criticism in light of the current low absorption levels.
Disbursements. Have loan officers approved disbursements with sufficient evidence that the project was within the approved budget? Additionally, is there independent confirmation that approval conditions have been met?
Guarantees. Examiners will criticize the lack of personal guarantees as showing “soft” underwriting.
Collaterally dependent loans. Loans in which cash flow has diminished may become “collaterally dependent,” with attendant write-downs required.
Credit administration. The credit administration function should be centralized with separation of duties. Loan proposals should be independently reviewed prior to submission to the board.
Reporting. Do loan policies call for a monthly report of the status of troubled CRE and ADC loans by the senior officers? Have these reports been made? Are there workout plans on all significantly criticized assets? Has the board been reviewing these plans?

Appraisals
Appraisals must include the current market value of the property in its actual physical condition and subject to the zoning in effect as of the date of the appraisal. Many bankers do not wish to order current appraisals because they will show deterioration in asset values and no one is paying to run these appraisals. Examiners are coming into financial institutions armed with an analysis of declines in real estate values in the market. Examiners expect that bankers will have ordered test appraisals. Accordingly, examiners are arriving ready to shoot down appraisals that they believe are old (close to a year or more), based on dated or obsolete comparables or otherwise not in compliance with safety and soundness regulations.

To fend off the brunt of this onslaught, bankers should have an enhanced appraisal review function. Bankers must undertake a comprehensive review of their appraisal review function to ensure that appraisals are based on regulatory standards, so that subsequent loss estimations are accurate. Bankers should be fully conversant with the regulations, especially the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) regulations regarding appraisals. For instance, in the last few years, some bankers stopped providing written requests for appraisals with instructions because the letter was a “form.” All appraisals on significant property should be pulled and re-examined. Again, test appraisals should be considered. When appraised values no longer justify a “pass” rating, the banker should seek new collateral and guarantees.

Allowance
These asset issues translate into additional provisions to the allowance for loan losses. Bankers have been trying to grow their allowances by equal monthly provisions. Although it may seem like heresy, in the short term it is more important to have an accurate allowance than it is to be profitable. The ramifications of an inadequate allowance translate through almost all of the ratings and will almost certainly translate into an administrative action of some kind. If the allowance is substantially inadequate, then formal administrative action is likely. In contrast, if a financial institution is losing money, then that will result in a lower rating on earnings and, to a lesser extent, on capital and management. Management that is running a bank with an inadequate allowance will be deemed to be unsatisfactory. Management running a bank that is losing money still can be satisfactory. Moreover, bankers who have taken provisions are thought to have recognized their institutions’ issues. They are afforded some trust by examiners for doing so. When examiners believe the allowance is inadequate, they feel that they have only addressed the tip of the iceberg and more issues will arise later.

Capital
Of course, what all this leads to is whether the financial institution has sufficient capital. How much capital is enough? Bankers should run their own analysis and put together their own projections. There needs to be enough capital to get them through to the other side of the current economic woes while maintaining acceptable ratios. Please see the client alert titled “With Apologies to Jan Brady: Capital, Capital, Capital,” dated March 2009. The regulators have drastically increased the benchmark ratios.

OCC Capital Letters
The Office of the Comptroller of the Currency (the “OCC”) has been sending letters to national banks advising them that they must establish minimum capital levels under 12 U.S.C. § 3907(a)(2). Although these letters look like “capital directives,” as discussed below they are not. Nonetheless, such a letter can be a precursor to a capital directive.

Title 12 U.S.C. § 3907 provides for a two-step process in establishing individual capital requirements for a bank. Part (a)(2) of 12 U.S.C. § 3907 provides that each federal banking agency has the authority to establish such minimum levels of capital for a banking institution as the agency, in its discretion, deems to be necessary or appropriate in light of the particular circumstances of the banking institution. In addition, part (b)(2) of 12 U.S.C. § 3907 provides that in addition to, or in lieu of, any other action authorized by law, the federal banking agency may issue a directive to a banking institution that fails to maintain capital at or above its required level as established pursuant to 12 U.S.C. § 3907(a).

The OCC’s regulations provide that, if the OCC determines that higher minimum capital ratios are necessary or appropriate for a particular bank, the OCC will notify the bank in writing of the proposed minimum capital ratios and will provide an explanation of why the ratios proposed are considered necessary or appropriate for the bank. The bank may then respond to any or all of the items in that notice. After the response period, the OCC will decide whether individual minimum capital ratios should be established for the bank and, if so, the ratios and date the requirements will become effective. The bank will be notified of the decision in writing.
Traditionally, the only time the OCC used the authority in 12 U.S.C. § 3907(a)(2) was in an administrative action with a capital component. Now the agency is using such powers for banks that are not problem banks, but regarding which the OCC believes circumstances dictate need more capital.

A bank that does not have or does not maintain the minimum capital ratios applicable to it under a § 3907(a)(2) letter will be subject to such administrative actions or sanctions as the OCC considers appropriate.

The establishment of minimum capital ratios for an individual bank is different from the issuance of a capital directive. A capital directive is a formal administrative action and it is public. A capital directive also triggers the bank to be deemed to be less than well-capitalized. Thus, a capital directive has significance in terms of Prompt Corrective Action (PCA) sanctions. In addition, failure to heed a capital directive is potentially punishable by civil money penalties. In contrast, the OCC is treating a letter, such as discussed above, as a possible precursor to a capital directive.

In essence, the OCC is using the authority under § 3907(a)(2) as a more formal way to push national banks to meet higher regulatory standards. The OCC has been pushing national banks to have at least an 8 percent leverage ratio and a “fully funded” allowance.

Administrative Actions

The number of banks operating under either formal or informal administrative action has skyrocketed. It seems that the bank regulators are reporting 40 to 50 banks per month entering into formal administrative action. This does not even include the number of institutions that agree to informal actions. Informal actions are generally not reported. The thrust of these documents is the capital provision. Generally, financial institutions will be required to achieve and maintain 8 percent leverage ratios and 12 percent risk-based capital ratios. Recently, there have been administrative actions with 9 percent leverage and 13 percent total risk-based capital ratios. There is room to negotiate these levels and the timing in which the capital ratios must be achieved. Nonetheless, I cannot stress enough the need to be proactive.

Important Ratios
Bankers need to remember these important benchmarks:

1. Texas Ratio = (nonaccruals + OREO)/gross capital funds (i.e., capital and reserves)

If TR > 100% = viability of bank becomes questionable

2. Coverage Ratio = classified assets/(Tier 1 capital + ALL)

If CR > 25–30% = bank is candidate for MOU or other informal action

If CR > 80% = bank is candidate for formal agreement, C&D or other formal action

3. Allowance Coverage Ratio is ALL/classified assets. New minimum ALL is 1.4–1.5% of loans

If ACR < 100%, then potentially a problem bank (industry average at June 30, 2009, was less than 70% — a 15-year low)

4. If provisions for loan losses are consistently less than charge-offs = potentially problem bank (more than a one-quarter blip)

5. If nonaccruals + OREO > 3% of total assets = administrative action likely. Anything above 1.0% of total assets is an issue to watch, especially depending on trend

6. If nonperforming assets > 5% of total assets = formal administrative action likely

New Withholding Rules
The Obama administration has promulgated new withholding rules for international transactions. I have attached a client alert regarding that topic.

Safe Harbor for Loan Modification Plans

The Obama administration announced its home affordable modification program (“HAMP”). HAMP provides a safe harbor for certain modifications of one-to-four-family mortgages. I have attached a client alert on HAMP.

Peter G. Weinstock
1445 Ross Avenue, Suite 3700
Dallas, TX 75202-2799
(214) 468-3395
pweinstock@hunton.com