Community Banks and the Dodd-Frank Act
Article Date: Monday, November 08, 2010
Written By: Robert Singer
For community banks, the Dodd-Frank Wall Street Reform and Consumer Protection Act brings to mind Eastwood’s breakthrough movie – “The Good, the Bad and the Ugly.” Like the movie, the good is hard to find, and the bad and ugly are readily apparent. The length of the Act makes a detailed summary of all its consequences impossible here. The following is a summary of the key provisions affecting community banks in North Carolina.
The Good and Perhaps Good
North Carolina state banks in the Charlotte, Wilmington and Asheville areas have been unable to branch into South Carolina and Georgia. Those states opted out of the federal interstate branching laws of the 1980’s, thereby requiring entry only by whole bank acquisitions. This created an entry premium for their home banks. The Act overrides these opt outs. When prosperous times return, North Carolina banks will be able to extend their footprints into South Carolina and Georgia through relatively cost efficient branching.
The Act also implements a necessary correction to Section 404 of the Sarbanes-Oxley Act (“SOX”). Public companies (including FDIC reporting banks and SEC reporting bank holding companies) with market capitalization of less than $75 million will no longer have to acquire an independent auditor’s attestation report on management’s assessment of internal controls over financial reporting. The good news – a savings of $50,000 to $100,000 a year; the bad news – far too many of our community banks qualify for the exemption.
There is another item of good news, perhaps. The FDIC charges premiums for its insurance coverage. In the past, they were calculated based on an institution’s deposits. The Act establishes a new assessment base composed of an institution’s average consolidated total assets, minus its average tangible equity. Large banks historically have been able to utilize a multitude of non-deposit, non-assessable funding sources which are less costly and more efficient to assemble than customer deposits. The result was, of course, the possibility of a better spread between cost of funds and interest earned than was available to smaller banks. At the surface, the new assessment base would seem to narrow the larger banks’ advantage by assessing premiums on the assets derived from these non-deposit sources. Below the surface, however, lurks possible bad news. If non-deposit funding becomes more expensive because of insurance assessments than deposit funds, the larger banks will use their widespread branch networks (and resulting ability to balance high and low deposit rate markets) to compete more aggressively for deposit dollars with community banks. This competition will likely increase interest rates on deposits. Good for those with dollars to deposit; not as good for the interest rate spread of community banks.
That is the end of the good/perhaps good news.
Some provisions of the Act are directed at all public companies. Most banks are publicly reporting companies as a consequence of their formation (a de novo community offering generally results in more than 500 shareholders). Similarly, most bank holding companies are public companies as they were just an upstream formation by public banks. Many of the Act’s provisions are directed at banks. In all of this, Congress seems to have been unable generally to distinguish between Wall Street and Main Street. The Act will significantly increase the costs of commercial banking. A 7% increase has been projected by one analyst. Hence the bad.
The Act requires public companies to include a non-binding say on pay resolution to approve the compensation of the companies’ “named executive officers” (generally the top five executives) every three years. Every six years, the proxy statement must ask the shareholders to decide whether this “say on pay” resolution should be presented every one, two or three years. This brings public companies roughly into accord with what is already required of banks receiving TARP funds from the U.S. Treasury.
In every public company proxy relating to shareholder approval of a merger, acquisition or similar transaction the issuer must submit a non-binding proposal for approval by the shareholders of the total compensation to be paid to any named executive officer of the company related to the transaction (i.e. golden parachutes).
Each annual proxy statement must contain two new disclosures. There must be a presentation comparing the company’s stock performance with the total compensation of the named executive officers (“pay for performance”). This seems to assume market performance is largely tied to the performance of those executives (fair enough to some degree, but a simplistic view of the markets). The second required disclosure is a ratio of the chief executive officer’s total compensation to the median total compensation of all other employees. One interpretation of these provisions might be that the named executive officers are largely responsible for market performance, but there should not be too much disparity between the compensation of the highest executive officer shouldering this burden and the median compensation of all other employees. A possible disconnect in logic. This could be a mistaken conclusion, of course.
All banks and bank holding companies (whether public or not) having $1.0 billion or more in assets must report to their federal prudential regulators the structures of all incentive-based compensation arrangements for directors, executive officers, employees or principal shareholders that provide excessive compensation or could lead to material financial loss. The regulators can prohibit any such arrangement. The formulation of the statute is, one can only assume, intentionally backwards. The result will be that a subject bank will submit an incentive compensation arrangement to its prudential regulator for approval before the arrangement is implemented. Although perhaps abrogating its fiduciary duty in a sense, a board would be foolhardy to do otherwise. Who would implement a plan a regulator has the right to reject as excessive or imprudent? Can a better derivative action be designed? Another question. Will an adverse pay vs. performance comparison and/or a CEO/median compensation ratio above some number create a strong inference of excessiveness for the relevant executives?
Another requirement is that if a public company must restate its financial statements because it reported erroneous data due to material noncompliance with the SEC’s financial reporting rules, it must clawback from any current or former executive officer who received incentive-based compensation during the three years prior to the restatement, the excess of incentive compensation over what would have been paid under the restatement. As yet, there is no clarity about whether there will be any scienter requirement, a collective guilt concept will be employed, or an opportunity to defend oneself will be offered.
These provisions of the Act may be substantive and useful with respect to large public companies. Their utility, given the relatively modest compensation structures of community banks and the attendant costs of compliance, is less certain for Main Street banks.
The Act authorized the SEC to require public companies to provide shareholders with access to companies’ proxy statements to nominate directors. The SEC issued regulations on August 25. They will be effective 60 days thereafter. The regulations provide that shareholders who have owned at least 3% of a company’s shares for three years or more may have their nominees included in the proxy materials sent to all shareholders. The nominees must meet all legal requirements, including applicable independence rules. No more than 25% of the total number of directors may be so nominated in any one election. The regulations’ effectiveness will be delayed for three years for “smaller reporting companies” (generally a company with a public float of less than $75 million).
Credit Risk Retention.
The current market for private mortgage-backed securities is immaterial (less than 3% of all mortgages currently being generated). Should the market be reborn, it may no longer be useful for community banks. Under the Act, the originator and securitizer of a securitized loan must collectively retain up to 5% of the credit risks of that loan. The allocation will vary based on the type of securitized loan, the relevant credit risk, whether incentives for imprudent origination are present, and the potential impact on the access of consumers and business to credit. Certain “qualified mortgages” (more later on this term) are exempt from the risk retention rules.
The regulations implementing these provisions will be issued in the coming months. But a few basic conclusions can be reached. First, banks will be required to retain credit exposure on loans they craft for special situations – loans they would have sold to a securitizer in the past. This retention would deplete already thin regulatory capital levels. Accordingly, banks will limit the specially crafted loans they make. Consumers will have less credit available. Second, independent mortgage brokers/wholesalers of loans other than qualified loans will largely disappear. Few will have the capital to retain the required credit risk.
Bureau of Consumer Financial Protection.
The Act creates this Bureau within the Federal Reserve, but it is not subject to Federal Reserve oversight. It will take over the consumer protection functions of the Federal Reserve, the OCC, the OTS, the FDIC, the NCUA and HUD. All providers of consumer financial products or services will be subject to the Bureau’s regulations (“covered persons”).
The Bureau will have vast regulatory authority. Moreover, it will have enforcement authority and the ability to prohibit practices it deems unfair, deceptive or abusive. Although it may not establish acceptable interest rates for extension of credit, the Bureau may ban products or services it deems in violation of the Act or its regulations. The Bureau is directed to create an array of reporting obligations for covered persons. For example, banks must collect an extensive list of information on each application for a loan to a “women-owned”, “minority-owned” or small business and submit all of this application data to the Bureau annually (whether or not a loan is actually made).
The Bureau will directly examine and supervise financial institutions with assets of more than $10 billion. Smaller institutions will be examined and supervised for consumer protection purposes by their federal prudential regulators. The Bureau may, however, attend these examinations and consult with the prudential regulators.
Many commentators believe that the Bureau’s mandate and widespread regulatory authority will have a perhaps unintended consequence. It will constrict the availability of consumer credit, and will do so in the midst of severe recession.
Mortgage Reform and Anti-Predatory Lending. The Act seeks to address Congress’ perceived flaws in the mortgage lending business by providing a number of new restrictions and restraints upon that business, many of which are under the jurisdiction of the Bureau. Specifically, the Act proposes to prevent the making of mortgage loans that borrowers do not adequately understand or are not financial able to repay. A few examples.
The Bureau will issue regulations prohibiting payments to mortgage originators for steering borrowers to mortgages that, for example, the borrowers cannot repay; have “predatory characteristics”; are not “qualified mortgages” (generally, vanilla, level principal payment, amortizing loans); create credit disparities among consumers of equal creditworthiness but different races, ethnicities, genders or ages; or that have other unacceptable characteristics. An originator who violates these provisions is subject to civil liability not to exceed the greater of the borrower’s damages or three times the originator’s compensation on the loan, plus costs and attorneys’ fees.
Lenders are required to follow a new regime of procedures to determine a borrower’s ability to repay a mortgage loan. These provisions establish a quite specific and lengthy list of required actions, and the Federal Reserve is to issue regulations further expanding the practices required.
If a mortgage lender violates the prohibition on paying steering incentives or fails to satisfy the ability to repay requirements, upon default the mortgage borrower may assert such violation as a full defense to the foreclosure action. In addition, the borrower assert a claim for damages suffered by reason of the violation. Any recovery is off set against the loan balance. So a bank may make a “bad” home loan (it was wrong about the borrower’s ability to repay) and violate a determination requirement, it forecloses, the borrower successfully defends, the bank has a defaulted loan on which it cannot recover, the borrower is living in the home, and the bank charges off the loan, thereby depleting its capital. One can only assume the assertion of such a defense will become common. Thus, logically, banks will further limit their mortgage lending to borrowers of higher creditworthiness. The result -- fewer mortgage loans to first time home buyers and persons of more modest means.
The foregoing is only a very quick survey of a very few of the Act’s provisions. This small sampling reveals, however, three basic concepts. First, Congress continues to be unable to distinguish between Wall Street and Main Street; between those bankers who have a rather tainted recent history in helping to create economic disruption and those who have suffered from that disruption. Second, Congress continues its move previously most apparent under the SOX to “federalize” many aspects of corporate law. Last, the ugly. The Act will increase the costs of doing business for banks and other consumer lenders, and will have the consequence of constricting the availability of credit to consumers and small business at the very time that credit availability is critical to our economy.
Bob Singer is a partner in the Greensboro office of Brooks Pierce and can be reached at 336-271-3123 or firstname.lastname@example.org . Bob practices in the areas of banking, mergers and acquisitions, public and private securities offerings, 1934 Act reporting, venture capital transactions, and general corporate matters.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.