FASB Sheds Light On CECL Delay Decision


CECL-8-15-19.pngSmall community banks are poised to receive a delay in the new loan loss standard from the accounting board.

The Financial Accounting Standards Board is changing how it sets the effective dates for major accounting standards, including the current expected credit loss model or CECL. They hope the delay, which gives some banks an extra one or two years, provides them with more time to access scarce external resources and learn from the implementation lessons of larger banks.

Bank Director spoke with FASB member Susan Cosper ahead of the July 27 meeting discussing the change. She shed some light on the motivations behind the change and how the board wants to help community banks implement CECL, especially with its new Q&A.

BD: Why is FASB considering a delay in some banks’ CECL effective date? Where did the issue driving the delay come from?
SC: The big issue is the effective date philosophy. Generally speaking, we’ve split [the effective dates] between [Securities and Exchange Commission] filers or public business entities, and private companies and not-for-profits. Generally, the not-for-profits and private companies have gotten an extra year, just given their resource constraints and educational cycle, among other things.

We started a dialogue after the effective date of the revenue recognition standard with our small business advisory committee and private company council about whether one year was enough. They expressed a concern that one [extra] year is difficult, because they don’t necessarily have enough time to learn from what public companies have done, they have resource constraints and they have other standards that they’re dealing with.

We started to think about whether we needed to give private companies and not-for-profits extra time. And at the same time, did we need to [expand that] to small public companies as well?

BD: What does this mean for CECL? What would change?
SC: For the credit loss standard, we had a three-tiered effective date, which is a little unusual. Changing how we set effective dates would essentially collapse that into two tiers. We will still have the SEC filers, minus the small reporting companies, with an effective date of Jan. 1, 2020.

We would take the small reporting companies and group it with the “all-other” category, and push that out until Jan. 1, 2023. It essentially gives the non-public business entities an extra year, and the small reporting companies an extra two years.

BD: How long has FASB considered changing its philosophy for effective dates? It seems sudden, but I’m sure the board was receiving an increasing amount of feedback, and identified this as a way to address much of that feedback.
SC: We’ve been thinking about this for a while. We’ve asked our advisory committees and counsels a lot of questions: “How did it go? Did you have enough time? What did you learn?” Different stakeholder groups have expressed concern about different standards, but it was really trying to get an understanding of why they needed the extra time and concerns from a resource perspective.

When you think about resources, it’s not just the internal resources. Let’s look at a community bank or credit union: Sometimes they’re using external resources as well. There are a lot of larger companies that may be using those external resources. [Smaller organizations] may not have the leverage that some of the larger organizations have to get access to those resources.

BD: For small reporting companies, their CECL effective date will move from January 2020 to January 2023. How fast do you think auditors or anyone advising these SRCs can adopt these changes for them?
SC: What we’ve learned is that the smaller companies wait longer to actually start the adoption process. There are many community banks that haven’t even begun the process of thinking about what they need to do to apply the credit loss standard.

It also affords [FASB] an opportunity to develop staff Q&As and get that information out there, and help smaller community banks and credit unions understand what they need to do and how they can leverage their existing processes.

When we’ve met with community banks and credit unions, sometimes they think they have to do something much more comprehensive than what they actually need to do. We’re planning to travel around the country and hold meetings with smaller practitioners — auditors, community banks, credit unions — to educate them on how they can leverage their existing processes to apply the standard.

BD: What kind of clarity does FASB hope to provide through its reasonable and supportable forecast Q&A that’s being missed right now? [Editor’s note: According to FASB, CECL requires banks to “consider available and relevant information, including historical experience, current conditions, and reasonable and supportable forecasts,” when calculating future lifetime losses. Banks revert to their historical loss performance when the loan duration extends beyond the forecast period.]
SC: There are so many different aspects of developing the reasonable and supportable forecast in this particular Q&A. We have heard time and time again that there are community banks that believe they need to think about econometrics that affect banks in California, when they only operate in Virginia. So, we tried to clarify: “No, you need to think about the types of qualitative factors that would impact where you are actually located.”

The Q&A tries to provide an additional layer of clarity about what the board’s intent was, to help narrow what a bank actually has to do. It also provides some information on other types of metrics that banks could use, outside of metrics like unemployment. It talks about how to do the reversion to historical information, and tries to clarify some of the misinformation that we have heard as we’ve met with banks.

BD: People have a sense about what the words “reasonable” and “supportable” mean, but maybe banks feel that they should buy a national forecast because that seems like a safe choice for a lot of community banks.
SC: Hindsight is always 20-20, but I think people get really nervous with the word “forecast.” What we try to clarify in the Q&A is that it’s really just an estimate, and what that estimate should include.

BD: Is the board concerned about the procrastination of banks? Or that at January 2022, banks might expect another delay?
SC: What we’re really hoping to accomplish is a smooth transition to the standard, and that the smaller community banks and the credit unions have the opportunity to learn from the implementation of the larger financial institutions. In our conversations with community banks, they’re thinking about it and want to understand how they can leverage their existing processes.

BD: What is FASB’s overall sense of banks’ implementation of CECL?
SC: What we have heard in meetings with the larger financial institutions is that they’re ready. We’re seeing them make public disclosure in their SEC filings about the impact of the standard. We’ve talked to them extensively about some of how they’ve accomplished implementation. After the effective date comes, we will also have conversations with them about what went well, what didn’t go well and what needs clarification, in an effort to help the smaller financial institutions with their effective date.

Boardroom on Fire: A Bank Chairman’s Painful Lessons from the Financial Crisis


chairman-4-9-19.png“A sheriff’s car pulls up—the bank is on lockdown.” David Butler wistfully recalls that day in 2009; the day he lost everything.

“It was pretty traumatic,” he admits. “You have to ask tough questions. Can we survive it? What do we do? What’s our exit strategy?”

The events that transpired that fateful Friday afternoon send shivers down the spines of every bank director—the worst case scenario. No, not a robbery. The other worst case scenario.

“The FDIC comes in. They lock the doors and secure all our records before anyone’s allowed to go home.”

Butler was a founding board member of Western Community Bank. Western was big, state-chartered and publicly-traded. In 2007, they acquired a chain of banks with a sizable chunk of money tied up in Florida real estate. It was a ticking time bomb—and, spoiler alert: it was about to go off.

The early fallout of the housing market crash saw Western hemorrhaging $6 million a quarter, making Butler’s board an easy target for regulators.

“The FDIC wanted litigation wherever they could get it; half the time, even where they couldn’t,” he groans. “The public wanted heads to roll and we made perfect targets.”

Western had a clean public shell; no run-ins with the SEC—they were squeaky clean. But as the recession raged on, it became clear that “clean” didn’t cut it. “People were investigated, detained even, based on what? The suspicion of malfeasance? Yet we saw banks engaging in improper, verging on illegal activity walk away scot-free.”

This federal fishing expedition left Butler with a lingering paranoia; the fear that an army of pencil pushers sporting black suits and earpieces might knock on his door to have their Mission Impossible moment at his expense.

One month into 2009, Western’s shares plunged 95 percent. The finger of blame inevitably found a target. “Our CEO was a great guy, but the recession hit him like headlights on a deer,” Butler laments. “We asked him to resign. It was one of the most painful things I’d ever done.” The resulting shuffle in leadership landed David in the role of acting chairman.

“My job primarily became keeping morale up as we scrambled to find a partner,” he recounts. “We didn’t want depositors losing money, but we didn’t want to lose depositors. If they’ve got half a million in the bank, telling them to move it is hard, but it’s the right thing to do.”

Depositors weren’t the only people Western risked losing. The FDIC shot down attempts to offer retention bonuses, leaving Butler at the mercy of employees’ goodwill. “How do you ask someone not to jump ship when they’re waist-deep in water?”

As Butler fought to keep all hands on deck, Western’s board was rocking from the turbulence of days spent sparring over the bank’s balance sheet and late-night conference calls consumed by quarrels over how and where they would stretch its tier one capital.

“You can’t measure the character of your board until it’s been strained.”

“We had our share of those who didn’t stay the course,” he concedes. “Some resigned; some pointed blame—but then there were the ones who stuck it out. Even when it looked hopeless; even when tensions ran high, their commitment never wavered. I hold those people in the highest regard to this day.”

It was an act of bittersweet mercy when, in May 2009, the other shoe finally dropped.

A cease-and-desist order earlier in the year saddled Western’s board with a bureaucratic obstacle course of audits, reorgs, policy rewrites and loan appraisals; with no less than 15 deadlined reports to the state banking commission. One of the many hoops the board was forced to throw itself through required a reevaluation of Western’s loan loss reserves; an amount they determined to be $33 million. Butler was called to meet with the FDIC shortly thereafter.

“They sat me down and told me we needed $47 million,” he says. “I told them they were about to close my bank. We all sat there silently for a minute.”

Three months later, the state banking commission seized control of Western Community Bank, just $2 million shy of meeting its reserve requirement. The bank was turned over to the FDIC and sold to a local competitor for pennies on the dollar.

Where was Butler—the man who risked it all—that Friday afternoon when they came to take it all away?

“Our legal counsel advised us to stay away from the transition to avoid any situation where we might be questioned without an attorney present,” he explains. “So my wife packed a picnic basket and we drove to the beach.”

What about the anger, the resentment, the righteous indignation at the hopelessness of it all? “There was plenty of that to go around,” he admits. “The fact that we could fail was all they needed to treat us like we would. But you reach a certain age where you don’t have time to be angry. There’s no use holding onto all that bitterness.”

A decade has passed since that Friday afternoon when Butler lost it all. Murmurs of a looming recession seep from the rich vein of alarmist gossip to circulate amongst those with a finger on the pulse. “If those kind of whispers reach your ears, it means you’ve kept one to the ground,” Butler posits. “If you’re a bank director, you’ve got a choice. You can pick that ear up off the ground and look towards the future. Or,” he adds with a grin, “you can bury the rest of your head.”

Are the Ducks Quacking?


IPO-5-17-18.pngAn initial public offering isn’t the only path to listing your bank’s shares on the Nasdaq or New York Stock Exchange, and gaining greater liquidity and more efficient access to capital via the public markets.

Business First Bancshares, based in Baton Rouge, Louisiana, opted for a direct listing on the Nasdaq exchange on April 9, over the more traditional IPO. Coincidentally, this was the same route taken a few days prior—with greater fanfare and media attention—by Swedish entertainment company Spotify. A direct listing forgoes the selling of shares, and provides an instant and public price for potential buyers and sellers of a company’s stock.

Business First’s direct listing could be seen as an IPO in slow motion. The $1.2 billion asset company registered with the Securities and Exchange Commission in late 2014, ahead of its April 2015 acquisition of American Gateway Bank. Business First then completed a $66 million private capital raise in October—$60 million of which was raised from institutional investors—before acquiring MBL Bank in January. The institutional investors that invested in Business First last fall did so with the understanding that the bank would be listing soon. “We actually raised money from the same people as we would have in an IPO process,” says Chief Executive Officer Jude Melville.

Melville says his bank took this slow route so it could be flexible and take advantage of opportunities to acquire other banks, which is a part of the its long-term strategy. Also, bank stocks in 2015 and 2016 had not yet hit the peak levels the industry began to see in 2017. The number of banks that completed an IPO in 2017 more than doubled from the prior year, from eight to 19, according to data obtained from S&P Global Market Intelligence.

“The stars aligned in 2017” for bank stocks, says Jeff Davis, a managing director at Mercer Capital. The Federal Reserve continued increasing interest rates, which had a positive impact on margins for most banks. Bank M&A activity was expected to pick up, and the Trump administration has appointed regulators who are viewed as being friendlier to the industry. “There’s a saying on Wall Street: When the ducks are quacking, feed them, and institutional investors wanted bank stocks. One way to feed the ducks is to undergo an IPO,” Davis says. Bank stock valuations are still high, and so far, 2018 looks to be on track for another good year for new bank offerings, with four completed as of mid-April.

The more recent wave of bank IPOs, which had trailed off in 2015 and 2016, was largely a result of post-crisis private equity investors looking for an exit. As those investors sought liquidity, several banks opted for life as a public company rather than sell the bank. That backlog has cleared, says Davis. “It’s still a great environment for a bank to undergo an IPO,” he says. “Particularly for a bank with a good story as it relates to growth.”

The goals for Business First’s public listing are tied to the bank’s goals for growth via acquisition. Private banks can be at a disadvantage in M&A, having to rely on all-cash deals. A more liquid currency, in the form of an actively-traded stock, is attractive to potential sellers, and the markets offer better access to capital to fuel growth. Melville also believes that most potential employees would prefer to work for a public versus a private company. “Being publicly traded gives you a certain stability and credibility that I think the best employees find attractive,” he says.

Business First’s delayed listing was a result of leadership’s understanding of the seriousness of being a public bank, and the management team focused on integrating its acquisitions first to be better prepared for the listing.

“You really have to want to be a public company and make the sacrifices necessary to make that possible,” says Scott Studwell, managing director at the investment bank Stephens, who worked with Business First on its pre-public capital raise but not its direct listing. “There has to be a lot of support for doing so in the boardroom.” The direct preparation for an IPO takes four to six months, according to Studwell, but the typical bank will spend years getting its infrastructure, personnel, policies and procedures up to speed, says Lowell Harrison, a partner at Fenimore, Kay, Harrison & Ford. The law firm serves as legal counsel for Business First. Roadshows to talk up the IPO and tell the company’s story can have executives traveling across the country and even internationally.

And the bank will be subject to Wall Street’s more frequent assessment of its performance. If a bank hits a road bump, “it can be a rough go for management in terms of looking at the stock being graded by the Street every day, not to mention all the compliance costs that go with being an SEC registrant,” says Davis. All of this adds more to the management team’s plate.

Considering a public path is an important discussion for boards and management teams, and is ultimately a strategic decision that should be driven by the bank’s goals, says Harrison. “What is the problem you’re trying to solve? Do you need the capital? Are you trying to become a player in the acquisition market? Are you just simply trying to create some liquidity for your shares?” Filing an IPO, or opting for a direct listing, should check at least two of these boxes. If the bank just wants to provide liquidity to its shareholders, a listing on an over-the-counter market such as the OTCQX may achieve that goal without the additional burden on the institution.

In considering the bank’s capital needs, a private equity investor—which would allow the bank to remain private, at least in the near term—may suit the bank. Institutional investors favor short-term liquidity through the public markets, which is why Business First was able to obtain capital in that manner, given its near-term direct listing. Private equity investors are willing to invest for a longer period of time, though they will eventually seek liquidity. These investors are also more actively engaged, and may seek a board seat or rights to observe board meetings, says Studwell. But they can be a good option for a private bank that’s not ready for a public listing, or doesn’t see strategic value in it.

Though Business First’s less-common path to its public listing is one that could be replicated under the right circumstances, the majority of institutions that choose to go public are more likely to opt for a traditional IPO. “The reality is that direct listings are very rare, and it takes a unique set of circumstances for it to make sense for a company,” says Harrison. While a direct listing provides more liquidity than private ownership, be advised that the liquidity may not be as robust as seen in an IPO, which tends to capture the attention of institutional shareholders. “Usually, it’s the actual function of the IPO that helps kickstart your public market activity,” he adds. And if the bank needs an injection of capital—and determines that a public listing is the way to do it—then an IPO is the best strategic choice.

The Dos and Don’ts of Shareholder Recordkeeping for Private Banks


shareholder-5-1-18.pngPublic and private banks are vastly different, but in some areas, they might be more alike that you may think.

Public banks are required to work with a transfer agent for their investor recordkeeping. Private banks, including institutions that are not listed on a stock exchange or regularly file financial reports with the Securities and Exchange Commission, do not have the same obligations as their publicly traded counterparts; however, this does not mean that sound recordkeeping practices are not just as important.

Based on my more than 30 years in the industry, these are the most important Do’s and Don’ts to consider when it comes to managing your investor records:

DO keep a close eye on your overall share balance. It is critical that the shares held on your share register match the number of shares outstanding that your financial reporting office says are there. Changes in shares outstanding (where there is an increase or decrease in this overall figure) don’t happen very often and may not cause an issue in your day-to-day business. But, if shares are not in balance, trouble will arise in the instance of a change-in-control event, such as an acquisition. The need to rehabilitate the list could complicate and delay the corporate event.

DON’T let share issuance discrepancies linger. When a share transfer takes place, the transaction must be recorded for both the transferor and transferee. For private banks, shares are often not liquid and transfers rarely happen. Given their rarity, it’s important to take special care to properly record transfers on the books of the company. Errors can be hard to find later on— especially when the person who had a photographic memory of the list has retired. It’s best not to let discrepancies happen in the first place, but if they do, resolve them now and avoid a messy accounting issue much later on.

DO pay special attention to executive equity awards. It’s usually not a good idea—or a good career move—to keep improper and inaccurate equity award records of your executives and directors.

DON’T underestimate the importance of data security. Keeping accurate shareholder records is important. Safeguarding that information is even more important. This means protecting data from both outside intrusion and weak internal processes that could threaten it. Data security and security breach notifications are also legal matters that need to be addressed to comply with state and federal law.

DO maintain regular communications with your investors. Part of the C-suite’s business is to continue to attract investors to the company—both to help boost the demand for the stock but also to try to attract some liquidity as well. You can make the C-suite’s job easier by delivering timely communications to your existing investors, keeping them happy.

DON’T lose sight of your regulatory obligations. Companies that file with the SEC obviously need to follow its reporting guidelines. But even those that don’t report to the SEC will need to comply with state or federal regulations applicable to the bank regarding governance and investor relations.

DO perform a regular review of your company charter and bylaws. You should have your counsel review these documents from time to time. This gives you the opportunity to make updates that support your business objectives. For example, you should consider the elimination of stock certificates if they are specifically mentioned in the bylaws.

Making this update allows for the use of book-entry statements (much like those one might see if they own a mutual fund or have their own brokerage account) and for more modern communications and proxy voting technology such as the electronic delivery of annual meeting materials and online voting. Your counsel will need to review applicable banking regulations to ensure these options are available.

Proper tracking of your investors and their holdings is as critical to the success of your business as your relationship with your banking customers. Adhering to strong governance and compliance practices will reduce opportunities for mistakes and risk going forward.

Do You Really Need a Bank Holding Company?


holding-company-2-23-18.pngThe boards of directors at three, multibillion-dollar, publicly traded banks recently chose to get rid of their holding companies. Bank of the Ozarks, BancorpSouth and Zions Bank, N.A. are now or soon will be stand-alone, publicly traded banks. For years, Republic Bank and Signature Bank have also operated as publicly traded banks without a holding company.

According to the public filings of Ozarks and BancorpSouth, the boards of those two organizations decided that having a holding company on top of their bank was way more trouble than it was worth in terms of dollars and time. The Zions board concluded that subject to regulatory approval, the bank would no longer be “systemically important” if it did not have a financial holding company structure. In the process, all three banks eliminated at least two regulators—the Federal Reserve, which oversees bank holding companies, and the Securities and Exchange Commission (SEC). None of the former holding companies were engaged in any significant nonbanking activities that couldn’t be conducted by the bank, either directly or through a subsidiary. For banks, the federal securities laws are administered by the bank’s primary federal banking regulator, rather than the SEC.

Life is a series of trade-offs, and none us can predict the future, but the increase in efficiencies for these organizations seems to have been worth giving up the flexibility afforded by operating in a bank holding company structure. For most banks that aren’t actively using their holding companies to engage in those non-bank activities that may only be performed under a holding company structure, the cost of eliminating the holding company is quickly recovered. If it turns out that eliminating the holding company was a bad idea, the Federal Reserve seems receptive to accepting and approving applications to form bank holding companies from many organizations, including those that had previously eliminated them.

Ozarks and BancorpSouth, like Signature and Republic before them, file their periodic reports under the Securities and Exchange Act of 1934 with the Federal Deposit Insurance Corp. Zions, which operates under a national charter, will make those filings with the Office of the Comptroller of the Currency. The shares of the banks are still listed on Nasdaq or the New York Stock Exchange.

Shareholders and analysts don’t seem to care that the banks’ filings are no longer available on EDGAR, an electronic filing system maintained by the SEC that investors can access. One can argue that bank holding companies that have over $1 billion in consolidated assets and thus are not eligible for the Fed’s Small One Bank Holding Company Policy Statement should consider whether their enterprise is getting its money’s worth from having a holding company—some are, and some aren’t. But remaining in a holding company structure simply because that is the way you’ve always done it is not sufficient analysis to withstand even polite questions from your shareholders.

The process of becoming a stand-alone bank is not intimidating for folks who know their way around the corporate and regulatory world in which banking organizations operate, but there are a number of important questions that bank boards need to consider, including: “Can we execute our business plan without a holding company?” Also, “Are the corporate laws applicable to banks chartered in our state as flexible as the laws applicable to our holding company?”

Three prominent banking organizations making a move like this in a six-month span might not signal a new trend, but it should cause directors at other banks to ask whether they really need a bank holding company.

Banking Blockchain: Making Virtual Currencies a Reality for Your Bank


blockchain-10-17-17.pngBlockchain-based virtual currencies are gaining in popularity and evolving quickly. Blockchain currencies often are described as disruptive, but also have the potential to radically revolutionize the banking industry in a positive manner. The reality is that blockchain currencies may develop into a useful tool for banks. Their acceptance, however, is hindered by their own innovative nature as regulators attempt to keep pace with the technological developments. Potential blockchain currency users struggle to understand their utility. Despite these hurdles, many banks are embracing opportunities to further develop blockchain currencies to make them work for their customers.

What Are Virtual Currencies and Blockchain?
Virtual currencies, also referred to as “digital currencies,” are generally described as a digital, unregulated form of money accepted by a community of users. Currently, blockchain currencies are not centrally regulated in the United States. For example, the federal government’s Financial Crimes Enforcement Network (FinCEN) and the Securities and Exchange Commission view blockchain currencies as money, the Commodities Futures Trading Commission sees them as a commodity, and the Internal Revenue Service calls them property. The IRS has attempted to define virtual currency as:

a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value [and] does not have legal tender status in any jurisdiction.

FinCEN, the agency with the most developed guidance regarding virtual currency, regards it in a more practical fashion as a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. Whatever the regulatory definition, virtual currencies need more certainty in form and function before their use becomes commonplace.

Blockchain technology brings benefits to payment systems and other transactions that are quite revolutionary. Blockchain technology is essentially a decentralized virtual ledger (aka, distributed ledger), utilizing a comprehensive set of algorithms that records virtual currencies chronologically and publicly.

Some examples of blockchain currencies currently in use are Bitcoin, Dash, Ether, Litecoin and Ripple. These currencies are constantly evolving and are being developed by individuals, technology-based peer groups or financial institutions. In August 2016, a consortium of banks, led by UBS, Deutsche Bank, Santander and BNY Mellon, announced the development of the “utility settlement coin” or USC. The USC is meant to allow banks to transact payments in real time without the use of an intermediary. It is expected to go live in 2018.

Blockchain Currency Opportunities for Banks
Despite their reputation for being tools of illicit trade, blockchain currencies may be useful to banks in a variety of ways and can achieve certain benefits. Blockchain currencies could:

  • actually reduce fraud, including hacking or theft attempts, because the technology makes every step of the blockchain transparent.
  • reduce costs and risks associated with know-your-customer (KYC) programs because blockchain has the ability to store KYC information.
  • allow a financial institution to establish a new trading platform for exchange that eliminates intermediaries.
  • potentially could transform the payments industry. An obvious example is the USC, which permits payments to be made in real time, without the use of intermediaries; and strengthens the confidence in the authenticity of the transaction. Banks that are either able to establish a blockchain currency or adapt a proven technology for their operations will generate operational efficiencies and obtain a significant competitive advantage.

What Are the Regulatory Challenges?
Blockchain currencies currently are not centrally regulated in the United States. As discussed above, the lack of a uniform definition is a fundamental issue. FinCEN has classified any person or entity involved in the transfer of blockchain currencies as a money transmitter under money services business regulations.

As blockchain currencies continue to evolve, however, additional federal laws and regulations must be drafted to address the most substantial areas of risk. Some states are weighing in on the topic as well. For example, the Illinois Department of Financial and Professional Regulation recently issued guidance on the use of virtual currency in which the Department views virtual currency through the lens of the Illinois’ Transmitters of Money Act.

Additionally, the Uniform Law Commission is developing regulations that would, among other things, create a statutory structure (for each state that adopts it) to regulate the use of virtual currency in consumer and business transactions. Regardless whether the federal government or the states enact legislation affecting blockchain currencies, a more uniform regulatory approach would greatly aid their development and utility.

Conclusion
Blockchain currencies, and the laws and regulations governing them, are in a promising state of development. As new technologies emerge and existing technologies continue to evolve, banks are presented with real opportunities for innovation by successfully adapting blockchain for use by their customers. Those that figure it out are poised for real success.

The Board’s Role in the Transition to CECL


CECL-9-30-16.pngThis summer, the Financial Accounting Standards Board (FASB) completed its project on credit losses with the issuance of a new standard that brings one of the most significant changes to financial reporting that financial institutions have seen in decades: The incurred loss model for estimating credit losses will be replaced with a new model, the current expected credit loss (CECL) model. In many cases, the new credit loss calculations are expected to result in an increase in the allowance, and, thus, might have a significant impact on capital requirements. Banks will need sufficient time to prepare and adjust capital planning and capital management strategies.

Banks are educating themselves on the changes, and boards of directors should be aware of the challenges faced by the banks they oversee.

As with any major initiative, a successful transition to the new standard will require the active involvement of the audit committee, the board of directors, and senior management. Given the audit committee’s responsibility for overseeing financial reporting, it has a critical role to play in overseeing implementation.

Recently, speakers from the Securities and Exchange Commission’s (SEC’s) Office of the Chief Accountant have emphasized the role that audit committees should have in implementing new significant accounting standards. In his speeches at Baruch College and the AICPA Bank Conference, Wes Bricker, interim chief accountant, addressed CECL implementation. Likewise, the federal financial institution regulatory agencies have addressed the role of the board in implementing the new credit loss standard. The agencies issued a joint statement on June 17, and in March the Federal Reserve System (Fed) released an article, “New Rules on Accounting for Credit Losses Coming Soon.” The speeches, joint statement, and article highlight tasks that boards of directors and audit committees may consider during transition, including:

  • Evaluate management’s implementation plan, including the qualified resources allocated for execution.
  • Monitor the progress of the implementation plan, including any concerns raised by the auditors or management that might affect future financial reporting.
  • Understand the changes to the accounting policies that are required for implementation.
  • Understand management’s transition to any new information systems, modeling methodologies, or processes that might be necessary to capture the data to implement the standard.
  • Oversee any changes to internal control over financial reporting in transitioning to the new standard.
  • Review impact assessments of the new standards, including impact on financial statements; key performance metrics, including credit loss ratios, that might be disclosed to investors outside the financial statements; regulatory capital; and other aspects of the organization such as compensation arrangements and tax-planning strategies.
  • Understand management’s plan to communicate the impact of the new standard on key stakeholders, including the new disclosures required by the standards and disclosures made leading up to the adoption date. Those who file with the SEC will need to disclose information about standards effective in future periods, including the expected impact when adopted.

In evaluating management’s implementation plan, it is important to develop an understanding of management’s timeline for implementing the new standards and to be aware of the effective date. Recognizing that the definition of a public business entity (PBE) under FASB includes many financial service entities, the FASB split the definition to provide additional time for PBEs that are not SEC filers.

  • For PBEs that are SEC filers, the standard is effective in fiscal years beginning after Dec. 15, 2019, and interim periods in those fiscal years. For calendar year-end SEC filers, it first applies to the March 31, 2020, interim financial statements.
  • For PBEs that are not SEC filers, the standard is effective in fiscal years beginning after Dec. 15, 2020.
  • For all other entities, the effective date includes fiscal years beginning after Dec. 15, 2020, and interim periods in fiscal years beginning after Dec. 15, 2021.
  • Early adoption is permitted for all entities in fiscal years beginning after Dec. 15, 2018, and interim periods in those fiscal years. That means, any calendar year-end entity may adopt as early as the March 31, 2019, interim financial statements.

While those dates might seem somewhat distant, there really is no time to lose in preparing for the transition.

Clawbacks Are Coming. Are You Ready?


clawbacks-8-1-16.pngFive years after the passage of Section 954 of Dodd-Frank adding new provisions on clawbacks, we expect the Securities and Exchange Commission (SEC) to make some minor adjustments to its proposal and adopt a final rule before summer’s end.

The proposal, which would amend Section 10D of the Securities Exchange Act of 1934, shifts responsibility for recouping excess compensation from the SEC to the registrant, creates a non-fault standard as opposed to the Sarbanes-Oxley “misconduct” standard, extends the clawback period to three years and significantly expands the number of executives subject to its reach. Almost all issuers publicly registered with the SEC, including smaller reporting companies and current or former executive officers, are covered. Small and emerging companies, which previously were exempt under Reg SK from making detailed compensation disclosures, will shoulder a disproportionate burden.

Which Officers Are Subject to Section 10D Clawback?
Unlike Sarbanes-Oxley, which only applies to the CEO and CFO, the proposal uses the definition of executive officer from Rule 240.16a-1. It includes principal officers as well as any vice president in charge of a principal business unit, division or function and any other persons who perform similar policy-making functions for the registrant.

What Triggers a Clawback?
The law requires that the company recoup excess compensation received during the three-year period prior to the date the issuer is required to prepare an accounting restatement. Again, unlike Sarbanes-Oxley, no misconduct or error on the part of the executive need be shown. The accounting restatement is the triggering event.

What Type of Compensation Is Subject to the Rule?
The proposed rule applies to all “incentive-based compensation,” which is defined as any compensation that is granted earned or vested based wholly or in part upon the attainment of any “financial reporting measure.” A financial reporting measure is defined to mean any measure derived wholly or in part from financial information presented in the company’s financial statements, stock price or total shareholder return. This is an expansion of the language of Dodd-Frank which states that the law applies to incentive-based compensation that is based on financial information required to be reported under the securities laws. The proposed rule excludes by its terms salaries, discretionary bonus plans, time-based equity awards or other payments not based on financial reporting measures, including strategic or operational metrics.

What Is Excess Compensation?
Excess compensation is defined to be erroneously awarded compensation that the officer receives based on erroneous information in excess of what would have been received under the accounting restatement. Examples include unexercised options, exercised options with unsold underlying shares still held and exercised options with underlying shares already sold. Similarly, all excess stock appreciation rights and restricted stock units awarded must be forfeited and if already sold, any proceeds returned to the company. The clawback would also apply to bonus pools and retirement plans based on the attainment of financial metrics. What should be emphasized is the law and proposed rule leave almost no discretion to the company. Clawback is mandatory except in cases where the pursuit of recovery would be futile or counterproductive.

What Is the Tax Consequence of a Clawback?
What is particularly troublesome is the tax complications. The most common problem is likely to be that the employee will be taxed fully on the original income. When income is paid back in a different tax year, it will be treated most likely as a miscellaneous itemized deduction and its full deductibility will be subject to whether the taxpayer has sufficient deductions to equal or exceed the 2 percent threshold of adjusted gross income. A clawback could have the effect of penalizing the employee through no fault of his own beyond the amount received.

How Should a SEC Registered Bank Adjust Its Compensation Approach?
Banks which may qualify to deregister should consider it. For companies that desire to remain registered or who have no alternative, then executives should consider purchasing insurance products with their personal funds to hedge against an unexpected loss of income already earned and spent. The SEC rule does not permit the issuer to indemnify or purchase insurance for the executive to cover clawbacks. What is unfortunate is that onerous rules governing circumstances out of the control of most executives only makes performance-based incentive compensation less desirable.

Preparing for the New Reality of Bank Activism


activism-4-8-16.pngFrom 2000 to 2014, activist hedge fund assets under management are reported to have swelled from less than $5 billion to nearly $140 billion. This sharp rise in assets under management is reflected in a 57 percent increase in activist campaign activity over the last five years. And while performance can vary greatly by fund, reports are that activist hedge funds have generally outperformed other alternative investment strategies in recent years. The upshot for the banking industry is clear: as more activist investors with more dry powder are looking for investment opportunities, activists have moved beyond the “low-hanging fruit” into regulated industries, including financial services, which had previously been considered too complex.

Banks historically were viewed as unlikely targets for activist investors. The burdens are significant on an investor deemed to “control” the bank (from a bank regulatory perspective). The investor must be concerned with an intrusive Change in Bank Control Act filing and fundamental changes may be mandated by the Bank Holding Company Act if the investor’s voting, director and activist activities result in it crossing often less than well-defined “control” thresholds. However, today’s activists have learned that even small holdings of a bank’s stock—for example less than 5 percent of voting stock—often suffice to generate the desired change and provide the desired return. Many activists thus have successfully achieved their objectives without triggering bank regulatory consequences.

As activist investors sharpen their focus on the banking sector, their criteria for which entities to target remain the same. Target companies generally share several key characteristics: underperforming (on a relative basis), broadly held ownership structures and/or easily exercisable shareholder rights. An underperforming business presents the potential for economic upside, while a dispersed ownership structure and easily exercisable shareholder rights provide access to the boardroom, or at least the ability to make demands. Activist stakes are often small as a percentage of overall capital and many activist campaigns rely on winning over institutional and other investors on measures to improve the performance of the business and, ultimately, the stock price. These measures can range from those intended to result in a sale of the bank, such as changing directors, to less disruptive, but nonetheless material changes, such as enhancing clawback features in executive compensation plans.

While no two activist campaigns are alike, activist engagement generally begins with a private approach to the board of directors or management. If the activist does not succeed in private conversations, more public disclosure of the activist’s campaign can take the form of public letters to the board of directors or management, public letters to stockholders, white papers laying out the activist proposal, or filings with the Securities and Exchange Commission related to ownership of the target’s stock. Finally, and at greater cost to the activist and target alike, activists can commence a proxy contest or litigation.

So how is a bank to know whether an activist has taken a position in its stock? For smaller, privately held banks, it is more important than ever to maintain close oversight of investor rolls. Publicly traded banks need to monitor Schedule 13D and Form 13F filings. An investor that accumulates beneficial ownership of more than 5 percent of a voting class of a company’s equity securities must file a Schedule 13D within 10 days. In an activist campaign, however, 10 days can represent a very long time and an activist can build up meaningful economic exposure through derivatives without triggering a Schedule 13D filing obligation. 13F filings are made quarterly by institutional investment managers. On the antitrust front, and likely more relevant to midsize and larger banks, an investor that intends to accumulate more than $78.2 million of a company’s equity securities must generally make a Hart-Scott-Rodino (HSR) filing with the Federal Trade Commission and notify the issuer of the securities. As with Schedule 13D filings, an activist can use derivative investments to avoid triggering an HSR filing. Given the limits of these regulatory filings, many publicly traded companies turn to proxy solicitors and other advisors who offer additional data analytics services to track a company’s shareholder base.

Boards must proactively prepare for such events. Any activist response plan will address a handful of key issues, including an assessment of the bank’s vulnerabilities, an analysis of the bank’s shareholder rights profile, engagement with shareholders on strategic priorities generally, identification of the proper team to respond to an activist approach, and ongoing analysis and monitoring of the shareholder base. No plan will address all potential activist approaches, but the planning exercise alone, done well in advance without pressures of an activist campaign, can position a bank to minimize exposure to activist pressures and to respond quickly, proactively and effectively to activist approaches.

Could You Be a Target of Shareholder Activism?


shareholder-activism-2-2-16.pngShareholder activism appears to be on the rise again, after subsiding somewhat during the financial crisis, and hedge funds are driving most of it, according to speakers Monday at Bank Director’s Acquire or Be Acquired Conference in Phoenix.

“They want to create public discussion and increase value through an increase in stock price or sale,’’ said Bill Hickey, co-head of investment banking for the investment bank Sandler O’Neill + Partners.

Activist hedge funds’ assets have risen 11-fold from 2003 to the third quarter of 2015, to $131 billion, according to Hedge Fund Research reports.  Banks are hardly immune. In fact, Sandler O’Neil analyzed acquisitions above $50 million in value for banks and thrifts traded on a major exchange since January 1, 2014, and found 61 percent of the sellers had activist shareholders involved. Recent targets have included New York-based Astoria Financial Corp., which announced a sale to New York Community Bancorp late last year shortly after Basswood Capital Management filed what’s known as a 13-D letter with the Securities and Exchange Commission, announcing the hedge fund had acquired a significant stake in the bank. Some activists have even ganged up on banks together, which was the case with Harrisburg, Pennsylvania-based Metro Bancorp; Cincinnati, Ohio-based Cheviot Financial Corp.; and Alliance Bancorp, Inc. of Pennsylvania, the speakers said.

Underperforming community banks are most likely the targets but bigger banks such as CIT and Bank of New York Mellon also have been subject to activist attacks. “In the last couple of weeks, we’ve heard more and more noise about the potential for larger organizations to be targets,’’ Hickey said. But really, almost any bank can qualify as a target. According to Hickey, traits that often attract activist investors include having a stock that trades at a discount to intrinsic value, having substantial cash or liquid assets, underperforming a peer group of banks, having inefficient operations, or even just having the potential to sell for a premium. Even private banks are subject to shareholder activism. Peter Weinstock, an attorney with Hunton & Williams LLP, said he has represented banks as small as $100 million in assets with proxy battles and family-owned banks whose shareholders do battle with the board.

While bank CEOs and boards generally despise them, activist shareholders argue that the pressure they apply to boards and management teams can lead to an increase in shareholder value and propel sluggish management teams to make improvements. Share prices often increase substantially after an activist hedge fund gets involved. Most often, activist hedge funds are looking for a sale of the bank, and if no suitable buyers appear, they go away, Hickey said. Sandler and Covington identified the major activist shareholders targeting banks right now, and they include PL Capital, Stilwell Value, Basswood Capital Management, Veteri Place Corp., Jacobs Asset Management, Clover Partners and Ancora Advisors.

Defenses against shareholder activists include tracking the bank’s performance to peers, as well as the bank’s shareholder rights practices and compensation in relation to peers, because that’s what the activists do, said Rusty Conner, an attorney with Covington & Burling. Boards should also pay close attention to shareholder advisory firms’ recommendations, especially if the bank has a significant institutional shareholder ownership. Also, Conner said it pays to beef up your communication with shareholders, and make sure you have a media relations and investor relations team ready to spring into action if your bank is targeted.

In general, banks are bit tougher for activist investors to crack, as they are heavily regulated and even gaining two seats on the board may constitute taking a controlling interest in the bank’s board, said John Dugan, an attorney with Covington. Investors who take a controlling interest potentially become subject to regulation as a bank holding company. Also, regulators have to approve a bank’s capital plan, including the payment of dividends and share buybacks, so struggling banks often are restricted in what they can do for shareholders.

Still, it pays to get your bank ready if you might be vulnerable to an attack.