Proposed Rule Summary

Advance Notice of Proposed Rulemaking (ANPR), Alternative Capital
Prepared by NASCUS Legislative & Regulatory Affairs Department
February 2017

NCUA has published an Advance Notice of Proposed Rulemaking (ANPR) on Alternative Capital. NCUA’s proposal uses the term “alternative capital” to encompass both secondary capital permissible for low income designated credit unions (LICUs) and supplemental capital which NCUA could authorize as counting toward risk based capital.

NCUA seeks information on a range of issues, including:

  • NCUA’s authority to include alternative capital for PCA purposes
  • What authority credit unions’ have to issue alternative forms of capital
  • Prudential standards for various instruments to qualify as capital for PCA purposes
  • Credit union eligibility for the sale of alternative capital
  • Investor protection standards, disclosure requirements, and investor eligibility standards
  • Implications of securities law on alternative capital
  • Implications of alternative capital on the credit union tax exemption
  • Needed regulatory changes to allow for supplemental capital and improve the usefulness of secondary capital for LICUs

The ANPR is in response to NCUA’s commitment to the CU system to consider providing for the use of supplemental capital by “complex” credit unions to meet NCUA’s PCA risk-based net worth requirements. In addition, NCUA is seeking comments on improving the regulatory framework for LICU use of secondary capital to meet PCA net worth requirements.

The Alternative Capital ANPR is available here.  Comments are due to NCUA by May 9, 2017.

Summary
The Federal Credit Union Act (FCUA) defines net worth as:

  • The retained earnings balance of the credit union, as determined under generally accepted accounting principles, together with any amounts that were previously retained earnings of any other credit union with which the credit union is combined;
  • Secondary capital of a low-income designated credit union that is uninsured and subordinate to all other claims of the credit union, including the claims of creditors, shareholders, and the Share Insurance Fund; and 
  • Certain assistance provided under section 208 of the Act pursuant to NCUA regulations.

Given the prescriptive nature of the FCUA, NCUA’s discretion in rulemaking is limited to secondary capital for LICUs and supplemental capital for risk-based net worth requirements. However, prudent rulemaking would establish standards adaptable for statutory net worth requirements in the event Congress modernizes credit union capital standards.

Current Use of Alternative Capital
NCUA seeks specific comments on how credit unions would use Alternative Capital:

  • What volume of supplemental capital would credit unions likely issue?
  • What structure of supplemental capital would be most beneficial to credit unions?
  • Why would credit unions issue supplemental capital and how would it fit into credit union business plans?
  • Who would purchase supplemental capital from credit unions?
  • How should regulations address the cost of supplemental capital and what can regulations do to lower the cost while maintaining protection for investors and the NCUSIF?

NCUA reviewed community bank usage of subordinated debt, noting that it had increased in 2016, but still only comprised .34% of bank capital. Banks generally gave 3 reasons for issuing subordinated debt: facilitate mergers & acquisitions, fund organic growth, and redemption of preferred stock held by the Treasury department.

The interest rate paid on subordinated debt varies but can range between 300-400 basis points above a 10-year Treasury note. Additional fees include legal and operational costs and sales commissions. Most buyers of bank subordinate debt are reported to be:

  • Pensions funds
  • Mutual funds
  • Other banks
  • High net worth investors

As of June 30, 2016, only 73 of 2,462 LICUs issued secondary capital totaling $181 million. This total equals about 13% of the net worth of the LICUs that have issued it. NCUA notes that just 4 LICUs account for a majority of outstanding secondary capital (74%). The interest rate paid by the 4 largest holders of secondary capital ranges between .14% and 3.5%.

NCUA acknowledges how helpful secondary capital has been to LICUs, adding an average 300 basis points to net worth. Of the 66 LICUs with secondary capital and net worth above 7%, only 41 would have 7%+ net worth w/o the secondary capital. However NCUA also notes that LICUs with secondary capital have a higher failure rate than their LICU peers w/o secondary capital.

Secondary Capital

  • Should LICUs be allowed to sell secondary capital to natural persons and if so, to only to members or to non-members as well?
  • Should LICU have greater flexibility to offer call options in the contracts beyond the portion no longer counting as net worth and subject to NCUA approval?
  • Should NCUA relax requirements for pre-approval of issuing secondary capital if the LICU meets certain conditions? If so what should those conditions be?
  • Should NCUA permit more flexibility to fund dividend payments as an operating loss if provided for in the contract?
  • What other prudential restrictions on secondary capital that should be considered?
  • Should NCUA reorganization its regulations to improve clarity by moving to part 702 (Prompt Corrective Action) all matters related to how the instrument must be structured to qualify for capital treatment?  (This would move these conditions to the section of NCUA rules and regulations applicable to all insured natural person credit unions, and leave the provisions specific to federal credit union issuance authority in Part 701.)

The current NCUA statutory and regulatory framework of secondary capital is as follows:

Statutory

Regulatory

  • Uninsured & subordinate to all claims of the CU, including claims of creditors, shareholders, & NCUSIF [most subordinated item on the balance sheet]
  • Only available for LICUs for purposes of statutory net worth
  • For LICUs
  • May only accept secondary capital from non-natural person members & non-members
  • Must receive NCUA pre-approval of a secondary capital plan
  • Must execute a Disclosure & Acknowledgement statement
  • About the Secondary Capital
  • Minimum maturity of 5 years
  • Reduce recognition of net worth value with less than 5 years maturity remaining
  • Must be available to cover operating losses that exceed net available reserves & to the extent losses are applied, accounts must not be restored
  • Cannot be pledged by investors as security on a loan
  • Subject to dividend restrictions per PCA as well as potential interest and principal payment limitation imposed by NCUA
  • Early redemption is limited and must be pre-approved by NCUA

The reduction in net worth value of secondary capital occurs pursuant to the following schedule: maturity between 4-5 years (80% value); maturity between 3-4 years (60% value); maturity between 2-3 years (40% value); maturity between 1-2 years (20% value) and maturity <1 year (0% value).

Supplemental Capital

  • NCUA seeks comment on whether the use of supplemental capital by non-LICUs would affect the availability of secondary capital for LICUs.
  • Does the FCUA allow for FCUs to issue supplemental capital in any form other than subordinated debt?
  • Should NCUA eliminate its 50% borrowing cap for FISCUs to provide FISCUs greater flexibility to issue supplemental capital instruments under state law?

NCUA’s ANPR estimates the usage of supplemental capital by natural person (non-LICU) credit unions.

# non-LICUs with net worth ratio 8%+ but a risk-based net worth ratio less than 13.5%

140

Those 140 CUs above have a total net worth of:

$9.2 billion

Maximum amount of subordinated debt that could be issued with a 50% limit:

$4.5 billion

Amount of supplemental capital needed by the 140 CUs to achieve a 13.5% risk-based net worth ratio:

 

$1 billion

  • Legal Authority

NCUA notes that there is no express authority for federal credit unions that are not low-income designated to issue supplemental capital However, the FCUA does provide FCUs with broad authority to borrow from any source in accordance with rules promulgated by NCUA. NCUA concludes that FCUs could only issue supplemental capital as subordinated debt. FCU borrowing is limited to 50% of paid-in & unimpaired capital.

NASCUS note: FCUA limitations do not apply to state credit unions. State credit unions may issue whatever forms of supplemental capital might be authorized under state law so long as those offerings are not explicitly prohibited by NCUA through share insurance regulation. Current rules limit FISCU borrowing to 50% of paid-in & unimpaired capital with the ability to seek a waiver up to any higher limit imposed by the state.

  • Note on Subordination

Pursuant to the FCUA secondary capital must be subordinate to all other claims. Supplemental capital on the other hand must be subordinate to the NCUSIF and uninsured shareholders, but but may be senior to secondary capital.

Taxation

  • NCUA seeks comments on whether expanded access to capital could undermine both the FCU and the FISCU federal tax exemptions.
  • Should NCUA limit FISCU supplemental capital instruments to those that NCUA is confident are not capital stock?

The FCUA specifically exempts FCUs from federal taxation and state taxation (except real & personal property). NCUA notes that part of the basis for the tax exemption is that most credit unions may not access the capital markets.

Unlike their FCU counterparts, FISCU tax exemption does not arise from the FCUA. FISCUs federal tax exemption is derived from § 501(c)(14)(A) of the Internal Revenue Code for state credit unions without capital stock organized and operated for mutual purposes without profit. State tax exemption derives from state law. There is no established definition of “capital stock” used by the Internal Revenue Service (IRS). NCUA notes the possibility that FISCUs in some states will have broad authority to issue supplemental capital instruments that have the characteristics of capital stock, inadvertently subjecting themselves to taxation.

Mutual Ownership

  • NCUA seeks comments on what rules it might impose to avoid issues related to impeding the members’ mutual ownership of credit unions.

Applicability of Securities Law

  • NCUA seeks comment on the applicability of securities laws to alternative capital.
  • Should credit unions issuing alternative capital be required to register with NCUA?
  • How could NCUA protect the NCUSIF against potential antifraud claims that could impair the alternative capital’s ability to cover losses?
  • Should NCUA mandate disclosures all credit unions issuing alternative capital must provide to investors? If NCUA mandates disclosures, should it base them on the SEC’s, the OCC’s, or create a unique set of disclosures for credit unions?
  • If NCUA creates a unique set of disclosures, what should it include in those disclosures? Should the level of disclosures vary based on the level of the investor (institutional, accredited, natural person)?
  • Should credit unions be required to develop policies and procedures to ensure compliance with anti-fraud requirements before issuing alternative capital?
  • How might NCUA ensure compliance with any state specific securities laws?
  • Should NCUA require credit unions certify that their activities related to issuance of securities are covered by their D&O coverage?

NCUA believes that both secondary and supplemental capital would be considered securities for the purposes of both state and federal law. While being subject to securities laws can trigger Securities Exchange Commission (SEC) mandated disclosures and anti-fraud rules, there are 2 exemptions likely available to credit unions:

  • Section 3(a)(5) of the Securities Act - available to certain types of financial institutions, including credit unions, for the issuance of any type of security
  • Rule 506 under Re. D under the Securities Act, which is available to any entity offering any type of security, provided that purchasers of the securities are “accredited investors”

The above exemptions apply to SEC disclosure requirements, however, SEC anti-fraud rules would still apply. Specifically, the Securities Exchange Act of 1934 §10(b) prohibits the use of deceptive or manipulative devices or contrivances in relation to the sale of a security. This makes it illegal to:

  • To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
  • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security

Determining the appropriate disclosures will be essential if credit unions seeks to issues alternative capital regardless of whether the offering is exempt from SEC filing or not. The nature/extent of required disclosure varies depending on multiple factors:

  • The nature/sophistication of the potential investors
  • The nature/complexity of the security being offered
  • The nature/complexity of the issuer’s business and the issuer’s industry
  • Types of disclosure commonly provided by peer companies

Disclosures must be clear, accurate, verifiable, and must not contain any misstatement of material fact omissions of material fact. NCUA notes that the OCC requires its supervised banks register securities with the OCC and use OCC mandated disclosures.

  • State Securities Laws

In addition to SEC considerations, many states have state specific securities rules and regulations. These state specific laws might require registration with the state, mandate payment of fees, and/or establish state anti-fraud/disclosure requirements.

  • Director Liability Coverage

NCUA notes its concerns that the sale of alternative capital may affect a credit union’s liability coverage for its directors and officers.

Other Investor Considerations

  • What investor suitable standards should govern credit union sale of alternative capital?
  • Should NCUA allow the sale of alternative capital to natural persons? If so, should there be limits on the amount and nature of the instruments?
  • Should NCUA allow the sale of alternative capital with equity like characteristics to non-members? If so, what safeguards would ensure continued member control of the credit union?
  • How might NCUA regulate the contractual process and investor access to information?
  • What other contractual limitations should be included in supplemental capital regulations?

NCUA rules limits LICU sale of secondary capital to non-natural persons. There is no statutory limitation on the sales. When the rules were promulgated, NCUA presumed purchasers of secondary capital would be philanthropic foundations and institutions.

NCUA questions the extent to which securities might be sold to individuals. In addition, NCUA notes that sales of supplemental capital will require detailed contracts between the credit union and the purchaser as well as the regular provision of information to investors regarding the credit union’s compliance with contractual terms and possibly regarding financial performance.

In addition, covenants in the alternative capital contracts cannot be allowed to impede NCUA or state regulatory authority to take any and all supervisory actions. Neither should covenants require the credit union to take actions that are in violation of any law or regulation or contrary to safe and sound operations.

Prudential Standards for Issuing and Counting Alternative Capital for PCA

  • Should alternative capital be available to cover payment of dividends in addition to covering “operating losses?”
  • NCUA also seeks comment on whether the definition of “operating losses” should differentiate between LICU secondary capital and supplemental capital.
  • How might NCUA balance the NCUSIF’s need for alternative capital’s permanence and availability with the expected “needs” of the secondary market?

To be considered regulatory capital (to count toward PCA net worth requirements) financial instruments must have a degree of permanence and the ability to absorb losses as a going concern. Currently, regulations provide that secondary capital be available to cover “operating losses” which has not been defined to include payment of dividends on shares. However, failure to make payment on shares could spark a liquidity and reputation risk, perhaps justifying inclusion of those expenses in the calculation of operating losses beyond retained earnings.

Furthermore, to protect the NCUSIF, any supplemental capital instrument must be capable of being cancelled without triggering default.

Approval to Issue Supplemental Capital

  • What pre-approval, if any, should be required prior to a credit union issuing/accepting alternative capital?
  • What post issuance, if any, notifications reporting should be required related to the issuance/acceptance of alternative capital?
  • Should credit unions meeting certain qualifications be exempted from pre-approval/notification requirements?
  • If credit unions are required to seek pre-approval, what standards should be used to evaluate whether approval should be granted?
  • Should NCUA restrict the ability of credit unions to offer varying tranches of supplemental capital?

NCUA rules require LICUs to submit a Secondary Capital Plan prior to accepting secondary capital. The plan must include:

  • The maximum aggregate amount of secondary capital the low-income designated credit union plans to accept
  • The purpose for which the secondary capital will be used and how it will be repaid
  • Demonstration that the uses of the secondary capital conform to the low-income designated credit union's strategic plan, business plan, and budget
  • Supporting pro forma financial statements covering a minimum of two years

NCUA also requires the LICUs to retain the original account agreement as well as the disclosures and acknowledgments for the term of the secondary capital.

Counting Alternative Capital for Regulatory Net Worth

  • NCUA seeks comments on how it should limit the amount of supplemental capital that should be allowed to count for net worth purposes.
  • What limitations should be placed on prepayment of supplemental capital?
  • How might NCUA prevent abuse of reciprocal holdings of alternative capital?
  • What rules are needed to ensure control of the credit union remains with members rather than investors?

NCUA seeks to ensure that credit unions do not become overly reliant on alternative capital as their primary source of regulatory capital. Banks are limited as the amounts of alternative capital they may use for regulatory purposes, and must maintain:

  • A common equity tier 1 capital ratio of 4.5%
  • A tier 1 capital ratio of 6%
  • A total capital ratio of 8%
  • A leverage ratio of 4%

To ensure alternative capital is truly available to cover losses, banking regulators place restrictions on prepayment:

  • Banks must obtain prior approval to prepay or call subordinated debt included in tier 2 capital
  • The holder of subordinated debt is prohibited from having a contractual right to accelerate principal or interest payments in the instrument, except in the event of a receivership, insolvency, liquidation, or other similar proceeding
  • Call options are prohibited in the first 5 years following issuance, except in certain very limited circumstances

NCUA also expresses concerns that reciprocal holdings of alternative capital would artificially inflate the level of capital in the credit union system. Generally, banks must deduct the holdings in other financial institutions that it holds reciprocally.

When a LICU mergers with a non-LICU, the secondary capital accounts are closed and paid out prior to the merger. NCUA notes that supplemental capital rules will have to ensure that investors cannot control voluntary merger decisions or otherwise wrest control of the credit union from the members.

Other Regulatory Changes

  • NCUA seeks comments on it treatment of, and limitations on, the acceptance of public deposits.Alternative capital as a funding source shares some characteristics with public deposit accounts. These accounts are governed by Part 701.32 and applies to FISCUs by reference in Part 741.204.
  • NCUA seeks comments on modifying the definition of insured shares in Part 741.4(b) to exclude any equity shares allowed under state law, if they are in fact uninsured.
  • NCUA seeks comments on modifying Part 741.9 to provide for the existence of uninsured accounts issued under state law by FISCUs.
  • NCUA seeks comments on any cohering changes needed to part 745.

Six Questions from the 2015 Rulemaking
During its 2015 risk-based capital rulemaking, NCUA asked a series of 6 questions related to supplemental capital. Noting that it received few responses to the questions, NCUA has again asked those 6 questions:

  • Should additional supplemental forms of capital be included in the RBC numerator and would including such capital protect the NCUSIF from losses?
  • If included in the RBC numerator, what specific criteria should such additional forms of capital reasonably be required to meet to be consistent with GAAP? Why?
  • If certain forms of certificates of indebtedness were included in the risk-based capital ratio numerator, what specific criteria should such certificates be required to meet to be consistent with GAAP and the FCUA and why?
  • In addition to amending the NCUA’s RBC regulations, what additional changes to NCUA’s regulations would be required to count additional supplemental forms of capital in NCUA’s RBC ratio numerator?
  • For state-chartered credit unions, what specific examples of supplemental capital currently allowed under state law do commenters believe should be included in the RBC ratio numerator, and why should they be included?
  • What investor suitability, consumer protection, and disclosure requirements should be put in place related to additional forms of supplemental capital?