On November 29, 2016, the FDIC, as part of its Community Banking Initiative, held an outreach meeting in Atlanta.  While the FDIC has indicated that it will publish a handbook regarding applications for deposit insurance in the coming weeks (which we’ll also summarize), we thought it made sense to provide a few highlights from that meeting:

Mechanics.  The mechanics of the chartering process are the same as before.

Business Plans.  As expected, there will be greater scrutiny on business plans, making sure that banks stick to their business plans post-opening, and (not expressly stated but as translated by me) ensuring that the results of the bank’s business plan do not deviate greatly from the original projections (i.e., providing for limited ability to take advantage of natural growth in the new bank’s markets or lines of business during the first three years of operations if not reflected in projections).  Approvals to deviate from one’s business plan will not be granted under most circumstances.

On November 6th, the FDIC issued an advisory letter discussing risk management practices that FDIC-supervised banks should implement with regards to purchased loans and loan participations. While the FDIC acknowledges the benefits accruing from the purchase of these loans and loan participations, such as achieving growth goals, diversifying credit risk, and deploying excess liquidity, the FDIC also recognizes that purchasing banks have oftentimes relied too heavily on lead institutions when administering these types of loans. In such a case, over-reliance on the lead banks has resulted in significant credit losses and failures of the purchasing institutions. Thus, while the FDIC reiterates its support for these types of investments, the FDIC also reminds banks to exercise sound judgment in administering purchased loans and participations.

A summary of the key takeaways from the FDIC’s advisory letter follows below:

• Banks should create and utilize detailed loan policies for purchased loans and loan participations.  The loan policy should address various topics, including but not limited to: defining loan types that are acceptable for purchase; requiring independent analysis of credit and collateral; and establishing credit underwriting and administration requirements unique to these types of purchased loans.
• Banks should perform the same level of independent credit and collateral analysis for purchased loans and participations as if they were the originating bank. This assessment should be conducted by the purchasing bank and should not be contracted out to a third party.
• The agreement governing the loan or participation purchase should fully set out the roles and responsibilities of all parties to the agreement and should address several topics, including the requirements for obtaining timely reports and information, the remedies available upon default and bankruptcy, voting rights, dispute resolution procedures, and what, if any, limitations are placed on the purchasing bank.
• Banks should exercise caution and conduct extensive due diligence when purchasing participations involving out-of-territory loans or borrowers in an unfamiliar industry. Banks should also exercise due diligence, including a financial analysis, prior to entering into a third-party relationship, to determine whether the third party has the capacity to meet its obligations to the purchasing bank.
• Finally, banks should not forget to include purchased loans and loan participations in their audit and loan review programs and to obtain approval from the board before entering into any material third-party arrangements.

The United States Court of Appeals for the Fourth Circuit, which governs North and South Carolina as well as Virginia, West Virginia and Maryland, has issued an important ruling in FDIC v. Rippy, a lawsuit  brought by the FDIC against former directors and officers of Cooperative Bank in Wilmington, North Carolina.  As it has done in dozens of cases throughout the country, the FDIC alleged that Cooperative’s former directors and officers were negligent, grossly negligent, and breached their fiduciary duties in approving various loans that caused the bank to suffer heavy losses.  The evidence showed the FDIC had consistently given favorable CAMELS ratings to the bank in the years before the loans at issue were made.  The trial court entered summary judgment in favor of all defendants, criticizing the FDIC’s prosecution of the suit as an exercise in hindsight.  The Fourth Circuit, however, vacated the ruling as it applied to the ordinary negligence claims against the officers.  In its opinion, the court held that the evidence submitted by the FDIC was sufficient to rebut North Carolina’s business judgment rule and thus allow the case to go to trial.  The Court found that the evidence indicated that the officers had not availed themselves of all material and reasonably available information in approving the loans.

The decision is specific to North Carolina-chartered banks and is based on the historical development of the business judgment rule in that state.  Nonetheless, there are certainly comparisons to be drawn to decisions from other states.  The emphasis on allegations of negligence in the decision-making process echoes last year’s decision in FDIC v. Loudermilk, in which the Georgia Supreme Court held that it was possible to bring an ordinary negligence claim against bank directors and officers who engage in a negligent process in making a decision.  While the Georgia Supreme Court in Loudermilk seemed to be of the view that it would permit claims to go forward against directors and officers who completely avoided their duties and acted as mere figureheads, the Rippy decision shows that in North Carolina, at least, the distinction between a viable case and one barred by the business judgment rule may be very fine indeed.  For instance, the FDIC’s evidence consisted largely of expert testimony that Cooperative’s officers failed to act in accordance with generally accepted banking practices by, among other things, approving loans over the telephone before they had examined all relevant documents, and by failing to address warnings and deficiencies in the bank’s (generally positive) examination reports.

In June, the Federal Deposit Insurance Corp. (FDIC) issued a rulemaking that proposes to revise how it calculates deposit insurance assessments for banks with $10 billion in assets or less. Scheduled to become effective upon the FDIC’s reserve ratio for the deposit insurance fund (DIF) reaching a targeted level of 1.15 percent, these proposed rules provide an interesting perspective on the underwriting practices and risk forecasting of the FDIC.

The new rules broadly reflect the lessons of the recent community bank crisis and, in response, attempt to more finely tune deposit insurance assessments to reflect a bank’s risk of future failure. Unlike the current assessment rules, which reflect only the bank’s CAMELS ratings and certain simple financial ratios, the proposed assessment rates reflect the bank’s net income, non-performing loan ratios, OREO ratios, core deposit ratios, one-year asset growth, and a loan mix index. The new assessment rates are subject to caps for CAMELS 1- and 2-rated institutions and subject to floors for those institutions that are not in solid regulatory standing.

A Quick Overview and a Note on Construction Lending

On June 16, 2015, the FDIC issued a notice of proposed rulemaking to revise its calculations for deposit insurance assessments for banks with under $10 billion in assets (excluding de novo banks and foreign branches).  The rules would go into effect the quarter after they are finalized but by their terms would not be applicable until after the designated reserve ratio of the Deposit Insurance Fund reaches 1.15%.

At almost 150 pages, there are many facets to the proposed rule that must be carefully analyzed.  At the outset, we give credit to the FDIC for attempting to fine tune deposit insurance assessments beyond the blunt instrument that they have always been.  We have long held the position that the FDIC should adopt more careful underwriting procedures, similar to private insurers, in order to better serve its function in the industry.

Under the proposal, a number of factors are used in a model to calculate a bank’s deposit insurance assessment rates:  CAMELS ratings, Leverage Ratio, net income, non-performing loan ratios, OREO Ratios, core deposit ratios, one year asset growth (excluding growth through M&A, thankfully), and a loan mix index.  All of these factors are intended to predict a bank’s risk of future failure, and all are worthy of discussion.
Putting aside our overall hesitancy to fully support faceless numerical models to draw important conclusions (anyone remember subprime lending?), we were initially drawn to the proposed implementation of the “loan mix index” as a factor for calculating deposit insurance assessment rates.  As we have previously discussed, construction lenders have recently been disadvantaged by the new HVCRE rules under the Basel III capital standards.  Once again, construction loans are the focus of regulatory scorn.

Ten years ago, business was booming for community banks—profitability driven by a hot real estate market, a wave of de novo banks receiving charters, and significant premiums paid to sellers in merger transactions. Once the community bank crisis took root in 2008, however, the same construction loans that once drove earnings caused significant losses, merger activity slowed to a trickle, and only one new bank charter has been granted since 2008. But as market conditions improve and with Federal Deposit Insurance Corporation’s (FDIC) release of a new FAQ that clarifies its guidance on charter applications, there are some indications that an increase in de novo bank activity may not be far away.

To understand the absence of new bank charters in the last six years, one must look to the wave of bank failures that took place between 2009 and 2011, which involved many de novo banks. Many of these banks grew rapidly, riding the wave of construction and commercial real estate loans, absorbing risk to find a foothold in markets saturated with smaller banks. This rapid growth also stretched thin capital and tested management teams that often lacked significant credit or loan work-out experience. When the economy turned, these banks were not prepared for a historic decline in real estate values, leading to a wave of FDIC enforcement actions and bank failures.

On December 24, 2014, the FDIC released its latest statements on what they consider to be “brokered deposits.”  In Guidance on Identifying, Accepting, and Reporting Brokered Deposits Frequently Asked Questions (the “FAQs”), the FDIC outlined their current views on what they will deem to be brokered deposits, formally stating positions that have been developing over the last few years but which had not previously been stated in writing.  For many FDIC-insured depository institutions (collectively, “banks”), the FAQs might have little or no impact.  For others, the impact could be significant.

Banks that have a large portfolio of brokered deposits know that they do, but these FAQs could expand the number of brokered deposits held by such banks.  It therefore is important to review the FAQs carefully to ensure that your call reports are accurate.  As discussed below, your volume of brokered deposits could even impact your FDIC insurance assessments.

There also may be those banks that believe they do not have any brokered deposits, except perhaps the reciprocal deposits obtained through CDARs, the Certificate of Deposit Registry Service.  This belief might not be accurate, and might be based on interpretations of the “primary purpose” exception that the FDIC does not share.  We recommend that every bank reconsider their brokered deposit holdings in light of the FAQs.

This article discusses the possible implications of having brokered deposits and the FDIC’s interpretation of what is or is not a brokered deposit as reflected in past FDIC Interpretive Letters and the FAQs.

The Brokered Deposit Rules and Consequences

Under Section 29 of the Federal Deposit Insurance Act (12 U.S.C. § 1831f) and its implementing regulation at 12 C.F.R. § 337.6, a “brokered deposit” is any deposit obtained, directly or indirectly, from or through the mediation or assistance of a deposit broker.  A “deposit broker” includes any person engaged in the business of placing deposits, or facilitating the placement of deposits, of third parties with insured depository institutions, or the business of placing deposits with insured depository institutions for the purpose of selling interests in those deposits to third parties.  There are a number of regulatory exceptions to this definition, but the FDIC applies these exceptions very narrowly, as discussed below.

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 very powerful rights that the FDIC possesses in any receivership is a provision added by FIRREA which states that the FDIC may enforce any contract entered into by the depository institution notwithstanding any provision of the contract providing for termination, default, acceleration, or exercise of rights upon, or solely by reason of, insolvency or the appointment of or the exercise of rights or powers by a conservator or receiver (i.e., “ipso-facto” clauses). Many typical vendor contracts will oftentimes contain just such a clause providing that one party to the contract can terminate the contract at will if the other party files for relief under the Bankruptcy Code or is taken over by the government. The logic is pretty compelling, a party wants to be able to decide if it is comfortable dealing with an entity that is insolvent or attempting to reorganize.

​A recent Georgia Court of Appeals decision raises interesting issues about how this specific FDIC power can be used in the context of a loan participation. In CRE Venture 2011-1, LLC v. First Citizens Bank of Georgia, First Citizens found itself the surviving bank of a group of four banks that had been involved in a loan participation. The lead bank and two others had been placed into receivership and the FDIC had sold the lead position to CRE Venture 2011-1, LLC. As is oftentimes the case in such situations, the local bank objected to the manner in which the lead was handling the credit, specifically, the proposed foreclosure of the real property securing the participated loan. First Citizens sought equitable relief based on its argument that if the foreclosure went forward, First Citizens would lose most of its interest in the loan and would be forced to account for the sale in a manner that would do it serious and irreparable harm to its finances and business prospects. First Citizens pointed out that unlike the two other loss-share banks that had succeeded to the other failed banks shares in the loan, it had not entered into a loss-sharing agreement with the federal government. Moreover, First Citizens argued that CRE Venture purchased the Loan at a significant discount and would not suffer the same loss, and might even profit from a quick sale of the property.

Both Banks and Their Vendors Must Pay Attention

Introduction

First there was the bulletin about third-party vendors issued by the Consumer Financial Protection Bureau (CFPB) in April 2012. Then it was the FFIEC’s guidance on IT service providers in October 2012.  Next came the FDIC’s September 2013 Financial Institution Letter about payment-processing relationships with high-risk merchants.  Then there was the news on October 30, 2013 about the OCC’s guidance on third-party relationships, followed shortly by the Federal Reserve Board’s guidance on managing outsourcing risks in December 2013.

Let’s face it. There has always been guidance and concern about banks and their relationships with third-party service providers. But in recent years it has become quite obvious that the bar has been raised on how banks relate to their third-party processors, program managers, and other service providers. These changes have occurred over time, by a matter of degrees. But it is increasingly plain that we are seeing a significant sea change in how regulators approach the relationships between banks and their third-party vendors. Examiners are digging deeper — especially into the content of bank contracts — and the scope of review is extending to more and more vendors.

In recent months, public commentary from some of the regulators has revealed even more clearly how this recent guidance will impact banks and their vendors. In this article we will describe the regulatory developments and provide some practical guidance as to what this will mean — not only for banks, but for their processors and other service providers.  (A print-friendly version is also available.)

Recent Regulatory Developments

Banks and other financial institutions have always been expected to choose their vendors carefully and to monitor the performance of those vendors. Most institutions have done a reasonably good job in this regard. However, recent regulatory publications and the focus of recent regulatory examinations and enforcement actions indicate that the standards and expectations are now much higher.

The CFPB issued a bulletin on April 13, 2012 regarding the use of service providers, accompanied by a press release stating, “CFPB to Hold Financial Institutions and their Service Providers Accountable.”  This bulletin, CFPB Bulletin 2012-03 (the CFPB Bulletin), states that the CFPB “expects supervised banks and nonbanks to oversee their business relationships with service providers in a manner that ensures compliance with Federal consumer financial law.” (emphasis added).