On September 16, 2010, the Senate adopted H.R. 5297, the Small Business Jobs Act of 2010, which includes the creation of the $30 billion Small Business Lending Fund. The House passed the Senate’s version of the bill in full on September 23, 2010, thereby sending it to President Obama for his signature. This legislation would (finally) implement the program described in President Obama’s State of the Union address (and first announced almost one year ago) from the beginning of the year to provide additional funds to community banks to lend to small businesses.
The version of the legislation is generally comparable to the version the Senate began considering in July but contains many differences from the version previously adopted by the House in June. Most significantly, the Senate-adopted bill does not permit eligible institutions to amortize losses and write-downs on certain OREO and NPAs secured by real estate. For convenience, we have posted the text of the Small Business Lending Fund provisions contained in the Senate-passed bill.
Under the terms of the Senate-adopted bill, eligible depository institutions with $10 billion or less in consolidated assets (as of December 31, 2009) may apply to receive a capital infusion of up to between 3% and 5% of the institution’s risk-weighted assets, less any existing TARP CPP or CDCI funds. Institutions with $1 billion or less in consolidated assets are eligible for up to a 5% investment, while those institutions between $1 and $10 billion are only eligible for 3%. (Under TARP, only institutions with $500 million or less in consolidated assets were eligible for capital up to 5% of risk-weighted assets, so this potentially represents an increase in available funding for institutions between $500 million and $1 billion.)
Institutions on the FDIC’s problem bank list are explicitly excluded from eligibility under the Small Business Lending Fund. The bill defines the problem bank list as the list of depository institutions having a current CAMELS composite rating of 4 or 5, or such other list designated by the FDIC. The bill explicitly emphasizes that merely because a bank has a CAMELS rating of 3 or better does not limit the discretion of the Treasury Department to deny an application for funds.
Matching with Private Funds.
The Small Business Lending Fund explicitly authorizes the Treasury and federal regulators to consider making an investment conditioned on private matching investments. This authorization is not available for institutions that are specifically ineligible (i.e., those on the troubled bank list) but rather is only available to otherwise eligible institutions that the regulators or Treasury determine not to recommend to receive capital infusions.
If the Treasury and federal regulators decide to recommend an investment under the Small Business Lending Fund that is conditioned on private matching investments, the Treasury may only invest up to 3% of the institution’s risk-weighted assets (notwithstanding if the institution’s total assets would have made them eligible to receive up to 5% of their risk-weighted assets). The private matching investment is required to be equal to or greater than 100% of, and subordinate to, the capital to be received under the Small Business Lending Fund.
Given the amount of discretion placed in the Treasury and federal banking regulators as to whether or not to recommend an investment, and then whether or not to condition such an investment on a private matching investment, it remains to be seen how this authorization will be used. However, as CAMELS 4- and 5-rated banks remain ineligible, the utility of the private match authorization is likely only to be useful for CAMELS 3-rated institutions, or possibly even CAMELS 2-rated institutions with concentrations in real estate loans.
Small Business Lending Plan.
In connection with the application for Small Business Lending Funds, a depository institution must deliver to the appropriate federal and state banking regulators a small business lending plan describing “how the institution’s business strategy and operating goals will allow it to address the needs of small businesses in the areas it serves, as well as a plan to provide linguistically and culturally appropriate outreach, where appropriate.” The plan will be considered confidential supervisory information, and therefore not made available to the public.
Small business lending is broadly defined in the bill to generally include all loans of less than $10 million to small businesses other than acquisition, development and construction loans. Importantly, loans under the small business lending plan (and included in calculations for determining the rate of the preferred stock) do not have to be SBA-guaranteed loans. Specifically, “small business lending” is defined in the bill to be:
(i) all commercial and industrial loans, owner-occupied commercial real estate loans, agricultural loans and loans secured by farmland
(ii) with original principal amounts of $10 million or less
(iii) made to businesses with no more than $50 million in revenues.
However, the bill also provides that the federal banking regulators shall establish, within 60 days after issuing any funds under the program, minimum underwriting standards that must be used for loans made by participating institutions. The terms of these minimum underwriting standards could have a significant impact on the willingness of institutions to participate in the Small Business Lending Fund and its ultimate success or failure in making additional credit available to small businesses.
The initial dividend rate for the investment under the Small Business Lending Fund will be 5%, with adjustments made based on the amount of changes in the bank’s aggregate balance of small business lending. Four and a half years after issuance, the instrument will increase to 7%, regardless of the level of small business lending. The instrument is required to be repaid within 10 years after issuance, or additional burdens, including higher dividend rates, may be imposed in the final instrument terms. The bill provides that these rates should be adjusted to reflect any differential tax treatments for S corporations.
For the first two years of the instrument, the rate will be adjusted quarterly based on the amount of the bank’s small business lending. Changes in small business lending will be measured against the average amount of small business lending reported by the bank for the four full quarters immediately preceding the enactment of the Small Business Jobs Act of 2010, less adjustments for loan charge-offs and loans acquired through purchase and merger. For the first two years:
- if small business lending has increased by less than 2.5%, the dividend rate shall be 5%;
- if small business lending has increased by 2.5% or greater, but by less than 5.0%, the dividend rate shall be 4%;
- if small business lending has increased by 5.0% or greater, but by less than 7.5%, the dividend rate shall be 3%;
- if small business lending has increased by 7.5% or greater, but by less than 10.0%, the dividend rate shall be 2%; and
- if small business lending has increased by 10.0% or greater, the dividend rate shall be 1%.
If a bank has increased its small business lending above its prior year average, the bank can take advantage of the reduced rates discussed above immediately upon issuance, based on the change in the small business lending level in the most recent call report versus the average amount reported in the prior four quarters. Otherwise, rate changes take effect the calendar quarter following the change.
Using percentage increases in the small business lending portfolio to determine the dividend rate could perversely encourage participation by institutions without a significant background in small business lending to participate. Banks with smaller existing portfolios of small business lending will more easily be able to achieve greater percentage increases in their portfolio (and thus greater declines in dividend rates).
However, presumably to prevent abuse by institutions with very small existing portfolios, any dividend rate reductions will not apply to a dollar amount of the investment made under the program that is greater than the dollar amount increase in the amount of small business lending realized under this program. The Treasury is authorized to issue guidelines implementing this limitation.
Based on the wording in the bill, a bank with $100 million in total assets and $10 million in existing small business lending could receive approximately $5 million in new capital (assuming no existing TARP CPP and 100% risk-weighting on all assets for simple math). If the bank increased its small business lending to $11 million, that would be a 10% increase and generally eligible for a 1% dividend rate. However, because the dollar increase in small business lending was only $1 million, the dividend rate would only be dropped to 1% on $1 million of instrument, with the remaining $4 million presumably continuing to call for a 5% dividend rate.
On the other hand, if the bank with $100 million in total assets had $50 million in existing small business lending, and increased its small business lending to $55 million, the entire $5 million investment would be eligible for the reduced 1% dividend rate (although smaller increases would limit the amount of the investment eligible for the intermediate rate reductions).
Accordingly, the Small Business Lending Fund will likely be most attractive to institutions that believe they can generate new small business loans in an amount equal or greater than the amount of the proposed investment, as once that threshold is met, there are no limitations on the amount of capital for which dividend rate reductions would apply.
At the end of the two years of adjustments, the rate in place at the end of two year-period will be the rate for the next two and a half years. However, if bank has not increased its level of small business lending as of the end of the two-year period, the rate shall be changed to 7 percent for the next two and half years. In total, banks receive two years of rates that adjust based on changes in small business lending (ranging from 1% to 5%), two and a half years of a fixed rate based on the change in small business lending (ranging from 1% to 7%), and then up to five and a half years at 7%. The Treasury is also authorized to issue regulations or guidance to establish other incentives to encourage repayment of the Small Business Lending Fund.
Refinancing of TARP CPP Funds
The bill calls on the Treasury to implement regulations to permit eligible institutions to refinance securities issued under the CDCI and the CPP for securities to be issued under the Small Business Lending Fund. While this refinancing would not provide any additional capital, it could both reduce the carrying costs of the capital and eliminate many of the executive compensation restrictions required under TARP. Accordingly, we would expect most eligible institutions with CPP funds to give serious consideration to refinancing. However, institutions that have missed more than one dividend payment due under their existing CPP funds are not eligible refinance under the Small Business Lending Fund.
Not TARP, but…
The Senate-adopted bill makes clear that the Small Business Lending Fund program is being established as separate and distinct from the Troubled Asset Relief Program, and that institutions shall not, by virtue of a capital investment under the program, be considered a recipient of TARP funds. Accordingly, the executive compensation restrictions that apply to TARP participants will not apply to institutions participating solely in the Small Business Lending Fund.
However, Congress cannot control public opinion or the news media, and therefore participants in the Small Business Lending Fund program may be painted with the same broad (and negative) brush as TARP recipients. If the program is to prove successful, the administration will need to emphasize both the investment nature of the Small Business Lending Fund and the tangible incentives to encourage lending.
Moreover, the bill permits the Treasury Secretary to implement additional terms “in order to manage risks associated with the administration of the Fund in a manner consistent with the purposes of this subtitle.” Accordingly, while the existing TARP executive compensation restrictions do not apply, the Treasury could, if it desires, implement comparable regulations for participants in the Small Business Lending Fund.
Any business receiving a loan from a participating bank “using” funds received under the program is required to certify to the bank that “the principals of such business have not been convicted of a sex offense against a minor.” Unless further guidance is provided, it would appear that participating banks would need to obtain this certification from all borrowers, as it would seem impossible to determine which loans were made or not made because of a particular source of capital. Congress didn’t seem to understand this under TARP and appears to continue to not understand how capital works.
In addition, none of the funds provided under the Small Business Lending Fund may be used to pay the salary of “any individual engaged in activities related to the Program” who has been officially disciplined for “viewing, downloading, or exchanging pornography, including child pornography, on a Federal Government computer or while performing official Federal Government duties.” Presumably this is intended to capture government employees involved in the Small Business Lending Fund, but the statute itself seems to swipe a broad swath by tackling any employee who is participating in “activities related to” the Small Business Lending Fund. I would not expect borrowers to have to certify that they will not use the borrowed funds to pay the salary of any individual so convicted, but participating banks may have to make such a certification. Hopefully, further guidance will be provided.