U.S. Basel III Proposals: Infographic

U.S. bank regulators have proposed to apply the Basel III capital rules to virtually all U.S. banking organizations. If adopted, the U.S. Basel III proposals would represent the most comprehensive revision to U.S. bank capital standards in over two decades. We have created some visuals that highlight certain key aspects of the U.S. Basel III proposals. An overview of the U.S. Basel III proposals and Davis Polk’s summaries of related Dodd-Frank bank regulatory rulemakings is available here.

View Davis Polk’s full-size visuals in pdf format including a timeline of U.S. Basel III implementation as proposed in June 2012.

Banks Dodge Superstorm Basel— for Now

storm.jpgThe entire U.S. banking industry breathed a collective sigh of relief recently when the three federal bank regulatory agencies postponed indefinitely the effective date of the Basel III capital and liquidity rules, which had been set for Jan. 1, 2013. The proposed rules, which would have applied more or less equally to all institutions—from the country’s largest bank, JPMorgan Chase & Co., to very small community banks in out-of-the-way rural locations—set off a firestorm of protest throughout industry.

Following their release in June, the proposed rules reportedly generated more than 2,000 comment letters from bankers as both the American Bankers Association and Independent Community Bankers of America orchestrated letter writing campaigns. Members of the U.S. Congress, including 53 senators from both parties, also expressed their concern during the comment period. And one prominent federal regulator—former Kansas City Federal Reserve Bank President Tom Hoenig, now a board member of the Federal Deposit Insurance Corp.—even urged that the entire proposal be scrapped and replaced with a simpler plan.

Community banks in particular were not objecting to higher capital levels per se since many of them—a great percentage of which are privately owned—have traditionally carried higher levels of capital on their balance sheets than large publicly owned banks, which tend to be more highly leveraged. But they did object strongly to certain Basel III provisions, such as a fairly stringent risk-weighting system that would have required them to put higher levels of capital against certain kinds of assets, including mortgage loans, commercial loans and even U.S. government securities. Basel III also would eliminate a highly popular form of Tier I capital at many small banks—trust preferred securities—from consideration, forcing them to raise new capital at a time when many investors, both public and private, are wary of banks generally. 

Some community bankers stated flatly that the new rules would force them to sell out if they couldn’t raise fresh capital. Others worried that the risk-capital weighting for mortgage loans would effectively shut them out of that business, negatively impacting their profitability and possibly the home buying market itself.

When announcing the postponement, federal regulators did not indicate how the Basel III rules might be modified or when they would take effect. The least likely outcome is that the feds will actually lower the overall capital requirements for banks, including very small ones, because there seemed to be widespread consensus in Washington coming out of the 2008 financial crisis that the banking industry needed to have a stronger balance sheet. A more likely outcome might be that the regulators create a simpler and less onerous risk weighting system for small banks, and then give them ample time to come into compliance with whatever approach they adopt.

One thing is for sure: Bankers often fuss and fume—with more than a little justification—that the regulators in Washington never listen to their complaints about the regulatory burden, but this time the feds heard them loud and clear.

How Will Basel III Impact Banks?

With Basel III looming, financial institutions are yet again bracing themselves for the changes to come from new regulation. In simple terms, Basel III will require banks of all sizes to maintain higher capital ratios and greater liquidity as a safety measurement, but what will this really mean for a bank? Several bank attorneys think lending will suffer, as many banks will have to focus on increasing capital and taking on less risky loans.

How will the new Basel III capital requirements impact the banking industry in the U.S.?

Luigi-DeGhenghi.jpgBasel III will generally require all U.S. banks, large or small, to hold more capital than under existing rules, especially in the form of common equity. The effect will be to incentivize banks to reduce their risk-weighted assets by reducing their exposures or their level of risk in order to maintain a sufficient return on equity to attract investors. The impact on bank mergers and acquisition activity is unclear. Increased capital requirements will drive banks as sellers, but will temper banks as buyers. But there will likely be a contraction in the supply of credit from banks, which may drive lending into less regulated parts of the financial sector. This seems at odds with the prevailing political push for more lending from banks and more financial regulation.

—Luigi L. De Ghenghi, Partner, Davis Polk

Gregory-Lyons.jpgIf adopted as proposed, the Basel III requirements will have a significant impact on U.S. banks of all sizes.  Community banks were surprised that they were subject to Basel III at all, and the higher substantive and procedural burdens on both residential and commercial lending can reasonably be expected to force many of them to exit the industry.  For the larger banks, much of what is in the U.S. proposals is consistent with what they have been tracking from the Basel Committee since late 2010.  Nonetheless, the higher capital charges likely will continue to force the shrinking of business lines in the short term, and severely inhibit large bank mergers over the longer term.  

—Greg Lyons, Debevoise & Plimpton

Mark-Nuccio.jpgThe impact will be positive in the long term.  Basel III’s higher capital requirements will be phased in over a number of years.  While many are eager for banks to become more generous lenders, Basel III’s capital demands encourage banks to husband their resources.  The new capital regime will be a drag on economic recovery, but it ought to produce greater long-term financial stability. 

—Mark Nuccio, Ropes & Gray

Jonathan-Hightower.jpgThe real impact will be the change on Main Street.  The proposed risk-weighting rules will require banks to tie up more capital with certain asset classes, which will cause banks to increase their pricing of those assets in order to achieve the same return on equity. Therefore, we can expect higher pricing for junior lien mortgage loans, highly leveraged first mortgage loans, and highly leveraged acquisition and development real estate loans.

This change in pricing will affect the demand for these loans, which will in turn limit the number of developers and homebuyers in the market. That contraction will impact both the supply and demand sides of the economic equation. At the end of the day, these changes will lead to a slower recovery of the facets of the economy related to housing and development.

—Jonathan Hightower, Bryan Cave

rob_fleetwood.jpgThe implementation of the Basel III regime will highlight the need for banks to be creative in their capital planning. We have already been assisting numerous community banks in capital raising initiatives to provide support for the development and implementation of lending and other income-producing programs, as well as strategic acquisitions or expansions. We are encouraging our clients, to the extent they have not done so already, to implement comprehensive capital plans that focus on careful management of existing capital resources and proactive research of available sources of future capital.

We have also been discussing with clients the ability to implement new lending programs, other non-interest income sources and deposit products in anticipation of the new requirements. If done correctly, these initiatives may provide additional resources for banks to grow, despite the new requirements. However, as with all new programs, they need to be carefully studied and managed to ensure compliance with all regulatory requirements, not just the new capital rules.

—Rob Fleetwood, Barack Ferrazzano

Peter-Weinstock.jpgBasel III and the changes to risk-based capital regulations provide substantial penalties, in the form of increased capital allocations, for risk taking.  Former chairman of the Federal Deposit Insurance Corp. Bill Isaac, in his book, “Senseless Panic: How Washington Failed America” demonstrated the pro-cyclical nature of mark-to-market accounting.  Yet, the Basel accord now mandates it for the securities portfolio.  The risk-based capital ratios dramatically increase the risk-weighting of several asset classes, including mortgages that are not “plain vanilla” and problem loans.  Because such penalties have a potentially severe impact on capital, prudent bankers will reduce their risk of a capital shortfall either by rejecting loans at the margin or maintaining higher capital cushions.  Either way, the credit crunch for all but the clearly creditworthy is likely to be exacerbated.

—Peter Weinstock, Hunton & Williams

The Benefits and Drawbacks of Going Private

The JOBS Act was about the only piece of bipartisan legislation to pass through Congress recently, according to Bruce Bennett, co-head of Covington & Burling LLP’s securities practice. It is supposed to facilitate job and capital formation by reducing disclosure rules for publicly traded companies with less than $1 billion in revenue, a new category deemed “emerging growth” companies. It also has a series of provisions to make it easier for banks and thrifts to stay privately held, enabling them to save costs. Bank Director magazine talked recently to Bennett about the impact of the JOBS Act on banks and thrifts.

What does the JOBS Act say about banks?

Previously, any company with more than 500 shareholders and $10 million in assets had to go public. Now, banks with fewer than 2,000 shareholders can stay private. The other trigger that was changed was the maximum number of shareholders you needed to deregister. Under the JOBS Act, banks no longer need to fall below 300 shareholders to deregister; the threshold is now 1,200 shareholders.

Other provisions apply to all “emerging growth” companies. The Act basically rewrites the rules for IPOs. It removes some fairly significant provisions. It reduces the duration of audited financial statements you need to go public from three years to two years. It allows for “test the waters” communications, so you can go out and talk to investors about whether they would want to make an investment in this company before you file your SEC (Securities and Exchange Commission) report. It reduces some of the public reporting requirements once the company goes public and the company gets the benefit of that for five years, unless it crosses the $1 billion annual revenue threshold sooner.

What impact do you think it will have on banks?

If a small bank is publicly traded, there is a cost to that. I’ve seen the cost estimate at $100,000 or more. If the bank doesn’t have to prepare SEC registration and reporting documents, it will probably save money. The investors who remain in the company will expect audited financial statements and most of the companies that have said they will deregister say they will continue to post those on their web sites.

If a bank is spending $100,000 to $125,000 per year to file SEC reports, and has 10 employees who could otherwise use their time more productively, then there is a benefit to that.

Are there drawbacks to deregistering?

The downside is this: What if in a few years the capital markets have changed and the bank wants to raise money in the public markets? If they have to do an IPO, that is more expensive than just staying public. It’s not good for companies to toddle in and out of public status. Investors would worry: Is this an investment I want to hold? It might make it harder to do the IPO. There also are some protections for a public company. If anyone wants to acquire more than five percent of a company’s stock, that person has to file with the SEC and the company knows who their large shareholders are. As a private company, you could have a large shareholder not aligned with your view as to how to manage the company and you don’t find out about it until that shareholder gets far more than five percent.

What size or type of bank do you think will be most interested in deregistering securities?

Small banks. We’re seeing an increase in stock-for-stock deals in mergers and acquisitions. If you’re a privately held bank, that sort of transaction is harder to do. If a bank is thinking of growing by acquisition, it would probably want to stay public. For a bank with assets in excess of $1 billion or $2 billion, I don’t see that category being interested in deregistering. I could also see regulators saying no, “If you do that, your access to capital is hurt from a safety and soundness perspective.”

Could deregistering hurt stock values?

If the standard metrics are strong, valuation will follow accordingly. If a bank has a compromised loan book and a lot of comprised real estate on the books, I don’t think being public would affect that. The way it would impact them is access to capital markets.

The JOBS Act has been billed as a way to create jobs. Will it?

I don’t think so from the banking perspective. The job creation could come from making IPOs easier to do. With that, you make it easier for small companies to grow or to do an IPO and they get better access to capital.

Audit Committee: Important Questions to Ask Regarding Your Strategic Plan

questions.jpgIt is obvious that the banking industry has undergone some dramatic changes over the past five years. The national and global economic crisis and the ongoing recovery have changed the playing field, making it more difficult for community banks to successfully operate with the same business plan as just a few years ago.

This new reality has made it increasingly important that audit committee members understand their institution’s strategic plan for the next three to five years so they can appropriately conduct their oversight role. This was a focus of my presentation at the Bank Director Audit Committee Conference in Chicago last month. After talking with audit committee members during a peer group exchange and throughout the general sessions, it was clear that some boards and management teams have gone to great lengths to make sure that they have developed a clear vision of the strategic plan and how their organization will adapt to the new environment, while other organizations have not yet turned their focus to the future.

With that in mind, there are a number of questions that audit committee members should be asking themselves, their board colleagues and their management teams:

What is our strategic plan?  It is increasing important that boards of directors and management teams have a clear direction as to the strategic focus and goals of their institution. Directors should determine with management the role that directors play in establishing the plan, measuring the institution’s progress with the plan and modifying the plan, as necessary.

How does our strategic plan affect our risk monitoring?  Different strategic goals may give rise to different risks and different risk management tools may be necessary. For instance, an institution that is focused on growth through acquisitions may have different risk thresholds and considerations than a company that is focused on steady, organic growth. These differences should be taken into account by the audit committee when approving the company’s internal audit plan and reviewing the internal audit reports.  

How is our relationship with the regulators?  It is crucial in today’s environment that your organization has a solid, respectful relationship with its regulators. As a director, you should be comfortable that your management team is responsive to the regulators’ questions and suggestions. Additionally, it is important that the directors can show the regulators that they are engaged in their oversight role and are exercising independent judgment. Directors should consider reviewing the lawsuits recently filed by the Federal Deposit Insurance Corporation against directors to understand some of the practices at other institutions that have led to potential director liability.

What is our current capital structure?  Regulators and investors place a heavy emphasis on capital levels and this will continue into the future. Basel III, the Dodd-Frank Act and the unspecified “regulatory expectation” will shape what future capital requirements will be for all institutions, regardless of size. Not only are there going to be higher capital requirements, but the components of capital will also change, with a clear bias toward more permanent common equity. Capital plays a key role in an institution’s strategic plan, and all directors should have a clear understanding of the following to help ensure that capital issues do not interfere with the company’s plan:

  • their institution’s current overall capital levels;
  • the different capital components and how their institution’s capital is comprised (levels of common capital vs. trust preferred, TARP preferred, subordinated debt, etc.);
  • how much capital will be needed in the future; and
  • how their institution can raise additional capital.

What is occurring with M&A in the industry? Are we going to participate?  Over the past 18 months, industry insiders have been indicating that a wave of consolidation is right around the corner. While the level of merger activity has remained somewhat muted, it is likely that there will be more activity in the near future. Directors should understand their institution’s M&A plan and how it fits within the company’s overall strategic plan. Whether or not the company is planning to be an active acquirer or is contemplating selling, it is important to understand the industry trends, what investors are looking for and what your competitors may be planning.  Additionally, it is important that all institutions have an understanding of what different opportunities exist within their market areas. Having such current knowledge will help ensure that the company can act quickly if the company’s circumstances change and participation in a strategic transaction is in its stockholders’ best interests.

What Bank Audit Committee Members Should Focus on Now

out-to-sea.jpgRobert Fleetwood is part of the financial institutions group and is the head of the group’s securities law practice area at law firm Barack Ferrazzano Kirschbaum & Nagelberg LLP in Chicago. Here, he talks about the increasing demands for capital and the trickle down impact of the Dodd-Frank Act, topics for the upcoming Bank Audit Committee Conference in June.

What are the kinds of questions you think audit committee members should be thinking about?

Many of our clients, particularly our private community banks, have recently been asking: “Where will we be in five years? What do we need to be thinking about?” With today’s regulatory environment, signs of recovery in the general economy and continued advances in technology, these are critical questions that all directors should be asking. I will be participating in a peer breakout focused on community banks at Bank Director’s upcoming Bank Audit Committee Conference to discuss some important issues for audit committee members.  Capital is of particular importance for all banks and I will discuss potential future capital requirements and what institutions can be doing now. I will address the role of the audit committee in risk management and the emergence of full risk committees. I will also talk about the mergers and acquisitions process and what all organizations should consider, whether or not they may participate in an M&A transaction.

Two of my partners will also speak at the conference. Joseph Ceithaml will participate in a breakout session regarding best practices that audit committees should consider to improve performance and will touch on topics including committee responsibilities, charters, the agenda-setting process, communication between meetings and committee membership. Additionally, John Geiringer will speak on some important regulatory issues, including recent Federal Deposit Insurance Corp. lawsuits and what boards of banks can learn from them to improve their practices.  

Will regulators require higher levels of capital in the future? How can community organizations access capital?

There continues to be debate about whether capital is king to a financial institution’s health and well-being, or whether other factors, such as liquidity, are actually more important. Regardless of one’s viewpoint, it is clear that regulators and investors place a heavy emphasis on capital levels and that this will continue into the future. Basel III, Dodd-Frank and the unquantified “regulatory expectation” will shape what future capital requirements will be for all institutions, regardless of size. Not only are higher capital levels expected, but the components of capital will also change, with a clear bias toward more permanent common equity. A key question for community banks is whether they will need to raise additional capital to implement their strategic plans and, if so, how will they raise the necessary amount. Many community banks have relied on directors and existing shareholders for additional capital. Changes to the private placement rules included in the recently adopted Jumpstart Our Business Startups Act (the JOBS Act) may make it easier for banks to solicit others in their community for additional capital.

Will Dodd-Frank have a significant impact on community banks? What do audit committee members need to know?

The Dodd-Frank Act has certainly played a significant role in financial institutions’ strategic planning over the past two years. However, there is still uncertainty over Dodd-Frank, with many questioning how it will be completely implemented and affect community financial institutions. There is also the potential impact of the upcoming elections and events outside the U.S. financial services industry. Almost two years after the enactment of Dodd-Frank, about 75 percent of the required rulemaking has yet to be completed. Of the rules that have been completed, only about half have become effective.  Over the last six months, regulatory agencies have begun to promulgate some of the major systemic risk rules that primarily affect the largest financial institutions. Many of the controversial proposals that attract most of the media attention are geared toward these larger institutions, including the Volcker Rule, capital stress testing and the preparation of the so-called institutional “living wills.” 

Many of the rules that will ultimately be developed under the Act will likely have a trickle-down effect on smaller institutions, either through actual regulation or prudential supervisory guidance. Additionally, regulators are currently focused on consumer compliance issues, with the new Consumer Financial Protection Bureau leading the way, and many of those rules are becoming more subjective in nature, making monitoring and ensuring compliance more difficult. With all of this uncertainty, all directors, including audit committee members, will need to closely monitor regulatory developments and continue to plan for increased regulatory and compliance costs. 

How to Raise Capital in a Difficult Market: What Investors are Looking For

raising-capital-session.jpgIt goes without saying that community banks have had a tough time raising capital in this environment.

One exception is Oritani Financial Corp., a $2.6-billion asset holding company for Oritani Bank in New Jersey, which has raised a total of $413.6 million since 2010.

Kevin Lynch, the company’s chairman, president and CEO, said at Bank Director’s Acquire or Be Acquired conference in Phoenix, Arizona, last month that raising money was an intense marketing effort that required lots of preparation and a good business plan.

Lynch and the bank’s chief financial officer met with 30 institutional investors in four cities over the course of a week.

“The questions come at you like bullets and you’ve got to let them know you’re running the bank and you know what you’re doing,’’ he said. “Your potential investors are going to say ‘does this guy know what he’s talking about?’ You should be prepared to say who your customers are and what your delinquents are and what you’re going to do about them.”

He said investors are interested in knowing whether you can grow organically and how you will deploy the capital.  Get to know the investors you are about to meet and learn what their goals are: is it a long term or short term investment for them?

Not all banks have had as good experience raising money as Oritani.

“Access to capital is critical,” said Stifel Nicolaus Weisel Executive Vice President and Vice Chairman Ben Plotkin, whose firm advised Oritani. “For banks trading well below book value, raising capital is a challenge.”

The problem is, a lot of banks are trading below book value. Banks with fewer than $1 billion in assets were trading on average at 72 percent to tangible book value as of mid-January, Plotkin said. That compared to about 120 percent price to tangible book value for banks with more than $1 billion in assets.

On average, larger banks have fewer balance sheet problems, and have had an easier time getting rid of problem loans.

Plotkin said investors are interested in banks with more than $1 billion in assets, with no looming balance sheet hole to plug, attractive demographics and ability to generate loan growth. They want a low level of non-performing assets, a loyal and low cost deposit base, and qualified management with a proven track record, he said.

Lynch also offered some other tips for raising money in the equity markets:

  • Have detailed knowledge of your portfolio and plans to build it
  • Know your largest loans and customers
  • Know all delinquent loans and how you are collecting on them
  • Know your asset quality levels, current market conditions and competition
  • Provide examples of lending and credit review practices
  • Know your loan pipeline and sources
  • Know how you will maintain credit quality while ramping up portfolio size

Using an ESOP to Raise Capital

Privately held community banks have had a tough time raising capital during the financial crisis and its aftermath. Investors are cautious and community banks have been especially challenged due to the economy’s troubles and investors’ desire for liquidity. One option for those banks is an Employee Stock Ownership Plan, or ESOP. Basically, an ESOP is a tax-qualified retirement plan that benefits all employees who meet certain criteria, such as 1,000 hours of service. An ESOP can use the tax deductible contributions made by a bank or bank holding company to purchase newly issued stock, thereby returning the cash to the balance sheet of the bank or holding company. These funds improve capital strength and could also be used to repay funds to the federal government’s Troubled Asset Relief Program. W. William Gust, J.D., L.L.M. of Corporate Capital Resources and Andrew Gibbs of Mercer Capital discuss some of the benefits of ESOPs and how they might help a bank raise capital.

How does it work?

The bank or bank holding company makes contributions to an ESOP, either in stock or cash, subject to certain limits. These contributions are allocated among participants in proportion to compensation or compensation plus length of service. An ESOP may use its cash to purchase newly issued shares or existing shares held by non-ESOP shareholders, as well as to purchase shares from participants exiting the plan.

What are the benefits of ESOPs for a bank?

Unlike retirement plans such as 401(k)s, ESOPs can purchase shares of the sponsoring S or C corporation. An ESOP can borrow money to purchase stock. Principal payments on the acquisition loan are tax-deductible. The ESOP is treated as a single, tax-exempt shareholder. S corporation ESOPs do not face the tax liability that otherwise would pass through to shareholders. As a hypothetical example, if the bank contributes $100 to the ESOP, it could save $40 in taxes and use the savings to purchase more bank stock, either to repay TARP or meet other capital raising goals. Because contributions are tax-deductible, purchasing newly issued shares is accretive to total equity, although the transaction would dilute the ownership interest of non-ESOP shareholders. While TARP requirements preclude key executives from non-qualified and discriminatory plans, they do not apply to ESOPs.

Why do banks make more use of ESOPs than companies in any other industrial classification?

Closely held banks often need a mechanism to acquire shares efficiently. An ESOP permits containment of the number of stockholders through an untaxed mechanism ultimately under the governance of the board. Most bank ESOPs are minority-interest owners.

What benefits do they have for participants?

The participants receive a retirement benefit as an equity interest in the sponsor at no cost to themselves. ESOPs typically reward loyal, long-term employees through vesting schedules, eligibility rules and the like, which cause the bulk of the plan assets to accumulate in their accounts.

In what instances would an ESOP not be appropriate?

ESOPs require a profitable sponsor, the ability to create value over time and a sufficient number of employees to meet the various compliance tests. Companies with fewer than about 25 employees or profits below about $500,000 (pre-tax, pre-ESOP) are not suitable, though there are exceptions. Since they have a market, widely traded public corporations do not often use ESOPs. Highly leveraged ESOPs often are inadvisable.

Who controls the stock?

The trustees are the legal owners who vote the stock for private corporations, except for major transactions. Participants in public company ESOPs vote all shares allocated to their accounts.

How is value established?

The trustee establishes value. For privately held banks, the trustee engages an independent appraiser to value the stock. Valuing banks in the current regulatory and economic environment is challenging; banking industry and ESOP expertise should be key considerations for the trustee in appraiser selection. Appraisers will consider numerous factors and apply specific valuation methods considered most appropriate. Draft regulations from the U.S. Department of Labor provide guidance specific to shares held by ESOPs.

Troubled financial institutions face their own compensation restrictions

stormy-board.jpgWhile financial institutions will shy away from the hint of a “troubled condition” designation, such designations are unfortunately a common fact of life in today’s economy. Many more banks and thrifts are finding themselves subject to new compensation restrictions when they fall into the “troubled” category. After an institution is determined to be in troubled condition, it becomes subject to the restrictions on golden parachute payments set forth in 12 C.F.R. Part 359 (“Part 359”).  If its condition continues to deteriorate, the institution might also become subject to the prompt corrective action (“PCA”) rules, which limits the ability to pay bonuses and increase salaries.

Overview of Part 359.  Part 359 limits the ability of financial institutions and their holding companies to pay, or enter into contracts to pay, golden parachute payments to institution-affiliated parties (“IAPs”).  The Part 359 troubled condition “taint” will flow from a troubled institution to its healthy holding company and also from a troubled holding company to a healthy institution (but not from a troubled institution, through a healthy holding company, to a healthy subsidiary).

An IAP is broadly defined and can include any director, officer, employee, shareholder, or consultant.  In certain situations, it can also capture independent contractors including attorneys, appraisers, and accountants.

A “golden parachute payment” (“parachute payment”) is any payment of compensation (or agreement to make such a payment) to a current or former IAP of a troubled institution that meets three criteria.  First, the payment or agreement must be contingent upon the termination of the IAP’s employment or association with the financial institution.  Second, the payment or agreement is received on or after, or made in contemplation of, a determination that, among other things, the institution is in troubled condition.  Third, the payment or agreement must be payable to an IAP who is terminated at a time when the institution meets certain conditions, including being subject to a determination that it is in troubled condition.  Even where a contract pre-dates the troubled condition designation, any parachute payment payable thereunder will be prohibited by Part 359 while the institution is in troubled condition.

Certain types of payments and arrangements are excluded from the definition of a parachute payment.  Generally, payments made under tax-qualified retirement plans, welfare benefit plan, “bona fide deferred compensation plans or arrangements,” and certain “nondiscriminatory” severance plans, as well as those required by statute or payable by reason of the death or disability of an IAP are excluded.

In addition to the general categories of excepted payments, the rules under Part 359 permit a financial institution to make certain parachute payments, or enter into agreements providing for parachute payments, where the institution obtains the prior approval of one or more regulatory agencies.  Such approval is required to pay obligations that pre-date the troubled condition, for the institution to pay, or enter into an agreement to pay, severance to someone who is retained as a “white knight,” or to enter into agreements that provide for change in control termination payments (that are contingent on both the occurrence of a change in control and termination of employment).  In nearly every case, if approval is granted, the approved severance payments will be limited to no more than 12 months of base salary (tax gross-ups will not be permitted in any form) to be paid over time and subject to claw back.

In October 2010, the FDIC issued Financial Institution Letter 66-2010 (“FIL-66-2010”) which expanded the information required to be submitted with an application for approval under Part 359 by requiring an institution to demonstrate that the IAP is not a “bad actor” and is not materially responsible for the institution’s troubled condition.  The guidance also provides for a de minimis severance of up to $5,000 per individual that can be paid without regulatory approval, so long as the institution maintains records detailing the recipient’s name, date of payment and payment amount, and also maintains a certification covering each individual who receives a payment.

Overview of Prompt Corrective Action Rules.  The PCA rules designate four capital categories: “adequately capitalized” (which is an institution in “troubled condition”); “undercapitalized;” “significantly undercapitalized;” and “critically undercapitalized.”  If an institution is significantly undercapitalized or critically undercapitalized, the institution becomes subject to additional compensation restrictions.  Undercapitalized institutions may also become subject to these additional restrictions.  When subject to the PCA compensation restrictions, the institution generally cannot pay any bonus to or increase the salary level of senior executive officers.