The Sub S Bank Report – April 2016 (Volume 19, Issue 1)

On December 3, 2015 the Board of Governors of the Federal Reserve System issued SR 15-15 after observing an increase in interest by some holding companies to establish arrangements that are designed to benefit certain shareholders, enhance short-term investor returns, and/or provide a distinct disincentive for investors to acquire or increase ownership in a holding company’s common stock and other capital instruments. The Fed noted that in some instances, the shareholder protection arrangements had negative implications on a holding company’s capital or financial position, limited a holding company’s financial flexibility and capital-raising capacity, or otherwise impaired a holding company’s ability to raise additional capital. The guidance noted the belief that the arrangements would impede the ability of a holding company to serve as a source of strength to its insured depository subsidiaries and were considered unsafe and unsound.

Examples of shareholder protection arrangements that have raised supervisory issues include, but are not limited to, provisions whereby:

• The holding company agrees to provide an investor with cash payments reflecting the difference between the price paid by the investor & a lower price per share paid by investors in subsequent transactions;
• The holding company agrees to provide an investor with additional shares of stock for minimal or no additional cost in the event that the holding company issues shares at a price below the price paid by the investor;
• Existing shareholders of the holding company are able to acquire additional shares at significant discounts to market value in a new offering if any shareholder crosses a specific ownership threshold;
• Investors with less-than-majority control are granted the contractual right to restrict, prevent the holding company from issuing additional shares; or
• The holding company’s board of directors has the authority to nullify share purchases under certain circumstances, require the holding company to repurchase the shares of the company from a new owner of the shares, or take other actions that would significantly inhibit secondary market transactions in the shares of the holding company.

The Federal Reserve noted a holding company, regardless of its asset size, should be aware that the Federal Reserve may object to a shareholder protection arrangement based on the facts and circumstances and the features of the particular arrangement. Therefore, a holding company that is engaged in capital raising efforts or is considering the implementation or modification of a shareholder protection arrangement should review this guidance to help ensure that supervisory concerns are addressed.

Seeking Clarification:
In early January we discussed the SR with Board staff involved in its drafting to express concerns on whether SR 15-15 was intended in any way to restrict banks or bank holding companies who have made the S election from utilizing stock transfer restriction agreements commonly called shareholder agreements which restrict transferability of stock to limit the number and type of shareholders who may own stock of these entities to provide certainty that the rules governing S corporations are met.

Our main goal was to seek clarification on the types of shareholder arrangements that would raise supervisory concern, such as the last bullet point referenced above where the holding company’s board of directors has the authority to nullify share purchases under certain circumstances, require the holding company to repurchase the shares of the company from a new owner of the shares, or take other actions that would significantly inhibit secondary market transactions in the shares of the holding company. The SR alert contained the following footnote: These arrangements could include complete prohibitions on share transfers, as well as certain forms of buy-sell agreements, rights of first refusal, or similar arrangements that sufficiently restrict the transfer of shares as to effectively prohibit most, if not all, transfers.

Specifically we asked whether the above provision and footnote quoted above was in anyway intended to limit or affect the terms of the typical Subchapter S shareholder agreement.

During our conversation, the Board staff confirmed that SR 15-15 was not intended to restrict Subchapter S shareholder agreements but was directed at investors coming into situations in which they were making an investment and imposing restrictions. We specifically referenced the provisions in the SR noted above including the footnote and the Board staff indicated that they had specifically discussed the typical Subchapter S shareholder agreements in connection with this provision and footnote and confirmed for us that this provision and the guidance in general is not intended to affect or limit these type of provisions in a Subchapter S shareholder agreement.

The Small Bank Holding Company Policy Statement (Policy Statement) effective in May of 2015 explicitly permits up to 75% long term debt (LTD) in the bank holding company (BHC) capital structure and allows up to 50% LTD without restriction on dividend payments or impacting expedited regulatory approval for M&A transactions. In December 2015, the House Financial Services Committee approved a bill (H.R. 3791) to increase the consolidated BHC asset size threshold applicable to the Policy Statement from $1 billion to $5 billion which, if adopted as law, would significantly expand the number of BHCs that could explicitly use more long term debt.

On October 30, 2015, the Board of Governors of the Federal Reserve System proposed Total Loss Absorbing Capacity Rules (TLAC) for the Global Systemically Important Banks (GSIB) BHCs which include 8 of the largest U.S. BHCs. When fully phased in on January 1, 2022, the TLAC rules will require that GSIB BHCs maintain 34% to 45% LTD in total eligible long term debt. These higher BHC LTD levels contrast sharply with the current Basel III rules (applicable to non-GSIBs with assets of $1 billion or more) which currently only include about 19% in LTD (subordinated debt) as a component of total capital. 

These recent developments with the small BHC Policy Statement in May and the proposed TLAC requirements in October indicate that there is an increased focus on greater use of long term debt in the capital structure for BHCs. As illustrated below, these capital rules differ substantially by asset size and result in a bar bell scenario where the largest and smallest banks in the U.S. can have substantially more debt in their capital structure than Basel III would otherwise permit. GSIBs with about 60% of the U.S. banking assets are required to have 34% to 45% long term debt while small BHCs representing about 87% of the total number of BHCs are currently permitted to have 50% to 75% long term debt. The BHCs in the middle with $1billion or more in assets but less than GSIBs (representing about 39% of total U.S. banking assets) will have only 19% debt and be at a distinct disadvantage in terms of weighted average cost of capital.

 All data related to number of institutions and total assets for U.S. BHCs and Savings and Loan Holding Companies based on SNL Financial as of December 23, 2015, using data for the quarter ended September 30, 2015.

As explained in more detail in Appendix C and using standardized costs of common equity of 12.00%, preferred equity of 7.00%, subordinated debt of 5.50% and senior BHC debt of 4.00%, the hypothetical after-tax WACC for a small BHC would be 7.43% compared to 8.07% for a covered BHC and 9.63% for a BHC with $1 billion or more in assets but less than GSIB in size. This WACC differential highlights the benefit of the higher debt mix in lowering the after-tax WACC. As illustrated in Appendix D, the WACC advantage that TLAC banks have relative to Basel III banks is offset by the higher total cost of capital due to the greater volume of capital required with 21% total capital/loss absorbing capacity vs 10.50% for Basel III and small BHCs. This results in higher total capital costs relative to the Basel III and small BHCs and reinforces why covered BHCs will continue to be under pressure to reduce their asset profiles to lower the volume of capital required to support their level of business activity.

Clearly, the Board and other regulators are comfortable with more debt in the BHC capital structure with small BHCs permitted to have 50 to 75% long term debt and GSIBs required to have 34 to 45%. This will likely encourage the BHCs with $1 billion or more in assets but less than GSIBs to add more debt to their capital structure to stay competitive with the WACC of other banking organizations. Properly managed within safety and soundness parameters, this could be a win/win for all parties as the banking regulators get more third party loss absorbing capacity into the banking system while bank management teams and Boards are able to add additional capacity to lend, which can certainly be used to stimulate economic growth and job creation.

Sources: Small BHC Policy Statement (April 2015), Basel III Capital Rules (October 2013), TLAC NPR (November 2015)

Thomas Killian has over 37 years of capital markets and M&A transaction execution experience, with a long history at Sandler O’Neill of developing innovative capital instruments and representing the firm in conferences and private meetings with the Board, FDIC, and others to discuss capital structure, restructuring and resolution strategies, and Basel III and DFA related issues. He can be reached at: tkillian@sandleroneill.com or 212-466-7709.

Editor’s Note – Mr. Killian’s article above is an outgrowth of his work on the TLAC proposed rules which included an extensive article he has published on the subject and a comment he submitted to the Federal Reserve. More information on the article and letter can be found at www.subsbanks.org. He is truly a thought leader in the community banking industry. Community banks and in particular Sub S banks have an excellent opportunity for capital growth, liquidity and shareholder succession management with the recent changes to the Small Bank Holding Company Policy Statement. While the proposed TLAC rules are not applicable to bank holding companies under $1b, the trickle down effect is always present as the industry knows from experience. As noted, the Fed’s endorsement of debt as a part of a bank holding companies’ capital structure is an important development.

In order to prepare for the potential decrease in capital with the current expected credit loss (CECL) model implementation, there are many strategies you can discuss with your tax advisor to potentially lower your taxable income and decrease tax distributions to shareholders. Each of these strategies can provide tax savings that could increase capital in the time before CECL becomes a reality. Here are a few ideas that could result in tax savings.

• Accrual to Cash Accounting Method Change – For some Subchapter S banks, an automatic accounting method change can be made to switch from accrual to the cash method of accounting for tax purposes. Banks are prime candidates for this change, as their receivables generally are higher than accounts payable and other accrued expenses. The spread between interest receivables and payables/accruals will be added or removed from taxable income; if receivables are in excess of payables/accruals, the bank will recognize a tax deduction for the net excess. You’ll need to discuss with your tax advisor if your institution is a candidate for the automatic accounting method change or if the institution would need to request permission from the IRS – along with payment of a user fee – to make the change.
• Prepaid Expenses – If your bank has been capitalizing prepaid expenses, you may be able to change your tax accounting method to begin deducting prepaid expenses in the year of payment. To qualify for this favorable method, the prepaid expense must meet certain requirements, including the benefit not extending beyond the earlier of the following:

1. Twelve months after the first date on which the taxpayer realizes the right or benefit
2. The end of the taxable year following the taxable year in which the payment is made.

There are other considerations when making this accounting method change that you’ll need to discuss with your tax advisor.

• Cost Segregation Studies – Banks also may take advantage of cost segregation studies to potentially accelerate tax depreciation deductions. For bank-owned buildings, the tax depreciation deduction will typically be taken over 39 years. A cost segregation study breaks down the total building cost into components that can be deducted over shorter time frames, thereby accelerating the depreciation deduction to earlier years. These accelerated tax deductions may help offset a decrease in capital with CECL implementation.
• Final Tangible Property Regulations – The IRS gives taxpayers a way to unload out-of-service building components currently being depreciated. If your building is being depreciated for tax as a single structure but you replaced the roof, remodeled or otherwise disposed of pieces of that structure in the past, you could be depreciating structures that no longer exist. For the 2014 tax year, you may be able to make a late partial disposition election to deduct the remaining basis of the items replaced in the past. For tax years 2015 and forward, a partial disposition is available, but only to the extent the component was disposed during the year and the replacement component is capitalized.
• Municipal Interest Income – Many community banks already take advantage of this tax-favorable treatment. Interest on municipal bonds or other municipal income sources is not taxable to your shareholders for federal purposes and may be exempt for state income tax purposes as well. It allows for capital increases not offset by tax distributions to the shareholders. Certain requirements must be met, but a discussion with your tax advisor can put you in position to begin using this tool.

Other strategies may be available. Discuss the issue with your tax advisor and let him or her know your CECL and capital-related concerns. With CECL implementation on the horizon, it may be time for Subchapter S institutions to start thinking of tax savings as methods to offset concerns of potential capital decreases under CECL. The BKD Thought Center, bkd.com/thought-center, has more information on relevant tax topics for banks.

Steve Cunningham is a member of BKD National Financial Services Group with more than six years of public accounting experience. His focus is on income tax consulting and compliance for financial institutions and bank holding companies ranging in asset sizes from $50 million to more than $3 billion. Steve can be reached at scunningham@bkd.com or 713-499-4753.

A recent study published in the Journal of Taxation in December 2015 has found that S corp banks pay higher wages and dividends to employees and shareholders. In addition, S corp banks pay slightly lower rates on deposits than C corp banks and charge slightly higher loan interest rates than C corp banks. The study noted the popularity of S corps which in 2012 represented 44% of all federal income tax returns. From 2001-2005, S corp banks paid 2% more in wages and 38% more in dividends than C corp banks.

The Association has been in touch with two of the three authors, Michael P. Donohue of the University of Illinois and Michael A. Mayberry of the University of Florida and is considering utilizing them to prepare a study on the benefits of Congress adopting HR 2789 and HR 3287. The professors will need to be compensated for their time and we would appreciate any member who has an interest in helping to fund such a study, estimated to cost approximately $30,000 to contact us. We believe this could be a valuable step in reaching our goals with respect to the Capital Access bills.

HR 2789 & HR 3287

The Association worked to have these two bills to be added to the omnibus extenders legislation. While both bills continued to pickup more co-sponsors, the extenders was limited to:

1. Current provisions that have expired/will expire and are usually part of a tax extenders bill;
2. Obamacare & stimulus related tax items
3. Misc. bills that meet the following criteria:

• has no revenue impact, but if there is a revenue loss it needs to be de minimis & must include an acceptable offset,
• has bipartisan support, and
• has passed either the Finance and/or Ways & Means Committee this Congress,

As a result both bills were left out when all was said and done.

In early January 2016, we had the opportunity to meet with Chairman Brady and Speaker Ryan to discuss both bills. We are hopeful that these efforts can lead to a hearing on the bills this session, laying the groundwork for passage.

Tax Extenders Signed Into Law

Just before recessing for the December holidays, the House and Senate passed the “Protecting Americans from TaxHikes Act of 2015″ (PATH Act.) On December 18th President Obama signed the PATH Act ” into law; which as a result allows over 50 expired tax provisions to be retroactively extended for the 2015 tax year. Unlike prior years, this year’s extender bill makes permanent over 20 of the expired tax provisions, including: the increased Section 179 fixed asset expensing limit, 100% gain exclusion for Qualified Small Business Stock, reduced recognition period for S-corp built in gains tax and others. In addition, many extenders have been enhanced.

The extenders bills was a big win for S Corp banks as it contained 2 key provisions. First, the permanent five-year period in which an S corp is subject to a built-in gains tax (essentially a double tax) when an S corp sells assets. The five-year provision on built-in gains has been a priority for several years with Representative Dave Reichert (R-Wash.) introducing legislation in the House Ways and Means Committee. Congress previously trimmed the threshold from 10 years to seven years in 2009 and 2010, then to five years in 2012, 2013 and 2014—but only temporarily, and that provision expired at the end of 2014. Second, the PATH act permanently extends the rule providing that a shareholder’s basis in the stock of an S corporation is reduced by the shareholder’s pro rata share of the adjusted basis of property contributed by the S corporation for charitable purposes. It applies to tax years beginning after December 31, 2014.

Tailor Act

The House Financial Services Committee recently passed H.R. 2896, which requires regulators to consider the risk profile and business model of the various classes of institutions subject to any regulatory rule, action or guidance. It further requires a determination of the necessity, appropriateness and impact of such regulatory action as well as the “tailoring” of such actions for various classes of institutions. This bill would also require regulators to report to Congress and review all regulations adopted over the five years prior to enactment. The legislation was introduced by Reps. Scott Tipton (R-CO) and Ed Perlmutter (D-CO).

Plan for Prosperity

ICBA launched its 2016 Plan for Prosperity. The updated regulatory relief platform aims to build on several policies from the previous plan that passed Congress last year. It also includes provisions to amend Basel III capital rules, better identify “systemically risky financial institutions,” expand mortgage regulatory relief, reform the CFPB and more. The full title, “Plan for Prosperity: An Agenda to Reduce the Onerous Regulatory Burden on Community Banks and Empower Local Communities,” clearly states the goal.

Patent Troll Legislation

Senators Jeff Flake, Cory Gardner and Mike Lee introduced S. 2733, the Venue Equity and Non-Uniformity Elimination Act (or Venue Act). With comprehensive patent troll legislation stalled in this Congress, this targeted venue limitation initiative would provide significant relief for banks and other small businesses dealing with expensive and burdensome patent troll cases.

19th Annual Subchapter S Bank Association Conference

OCTOBER 27-28, 2016
THE WESTIN RIVERWALK, San Antonio
Book your room now: http://tinyurl.com/jyvt8sp

Registration to open in April 2016

If interested in becoming more involved or have topics you would like covered email: atretvino@kslawllp.com