The Sub S Bank Report (Volume 14, Issue 2)

An employee stock ownership plan, or “ESOP,” is a tax-qualified retirement plan that is subject to many of the same rules 401(k) plans are required to follow.  However, unlike a 401(k) plan, ESOPs are designed to invest primarily in the plan sponsor’s stock and are allowed to borrow money to buy the stock.  There are hundreds of banks (approximately 250 of which are S corporations) across the country that sponsor ESOPs.  S corporations establish ESOPs for a variety of reasons such as providing shareholder liquidity, creating additional capital, retaining and incentivizing employees and encouraging an employee ownership culture.  S corporation banks can fund an ESOP by either contributing its stock to the ESOP (least common way), or by having the ESOP buy stock using either existing cash in the ESOP (including S distributions on shares in the ESOP) or incurring a loan from the plan sponsor to buy the stock.  If the ESOP buys stock, the Internal Revenue Service (IRS) and U.S. Department of Labor (DOL) have rules which must be followed by the ESOP trustee(s).  If the rules are not followed, the ESOP trustee and the bank’s board of directors, in its capacity as an appointing fiduciary, can be subject to fines and penalties under the Employee Retirement Income Security Act (ERISA).  Given the DOL’s recent initiative to audit ESOPs, this article will highlight rules an S corporation ESOP bank should follow when conducting stock transactions with its ESOP.

Any time an ESOP buys or sells stock, it cannot pay more than, or sell for less than, “adequate consideration.”  Section 3(18) of ERISA defines “adequate consideration” as the fair market value of an asset determined in good faith by the appropriate ERISA fiduciary (this is typically the trustee of the ESOP).  Internal Revenue Code Section 401(a)(28)(C) requires stock to be valued by an “independent” appraiser for purposes of purchases by or sales to an ESOP.  To qualify as “independent,” the appraisal firm should be engaged by the ESOP trustee (not the board of directors) and should not provide any services to the bank (including, but not limited to, merger valuations, gift and estate valuations and investment banking work) other than its work for the ESOP trustee(s).  If the appraiser is not independent, the DOL may allege the purchase or sale of stock by the ESOP was a prohibited transaction which could cause the transaction to be undone and could lead to excise and penalties taxes.

If the ESOP is buying stock from the bank, a director or officer of the bank, certain family members of a director or officer or certain large bank shareholders (10% or more) (collectively, “disqualified persons” or “parties in interest”), then the value of the stock purchased by or sold to the ESOP must be determined as of the date of the transaction.  Actually having the stock valued as of the date of the transaction is not just important, it is a requirement.  It is not sufficient to rely on the value from the most recent stock transaction outside the ESOP, nor is it appropriate to use the most recent stock value determined for the ESOP.  If a stock appraisal is not performed determining the value of the S corporation bank’s stock as of the date of the transaction and the ESOP is audited by the DOL, the DOL will require a stock valuation to be conducted as of the date of the transaction.  If the results of that valuation show the ESOP overpaid for the stock or the ESOP received less than it should have, then the DOL will assert the bank’s board of directors and the ESOP trustee breached their fiduciary duties.  The DOL will also assert prohibited transactions took place which must be corrected.  In some instances, the DOL has required the parties to “unwind” the transaction, which can be very expensive and time consuming.  Prohibited transactions may also require the parties to pay excise taxes to the IRS.

If the ESOP is not buying the stock from a disqualified person or party in interest, then the most recent ESOP appraisal can be used for the transaction price.  Since an ESOP is required to have its stock valued once a year, the stock value will be less than a year old.  The only exception to this rule which would require a more recent valuation is if the S corporation bank was aware of information indicating the most recent ESOP valuation was now materially inaccurate.  Even though a valuation is not required as of the date of the transaction, it is important to use the most recent ESOP valuation and not some other value used for other corporate stock transactions (unless that value is more beneficial to the ESOP).

If your bank sponsors an ESOP, it is critical the above requirements are followed for any purchases or sales of stock by an ESOP.  In the event the bank or ESOP trustee discovers the ESOP has been improperly buying or selling stock prior to a DOL audit of the ESOP, then all hope is not lost.  Improper transactions can be corrected under the DOL’s Voluntary Fiduciary Correction Program (VFCP).  There is no filing fee to participate in the program; however, the S corporation bank must make full correction of the transaction which will involve having stock valuations conducted and may involve additional contributions to the ESOP to make it whole for its damages as well as reallocation of shares and revised distributions.  A key benefit to participating in the VFCP is that no penalties will be imposed on the parties once the DOL has approved the correction.     If you suspect there are issues with your bank’s ESOP transactions, you should consult with legal counsel to determine the best course of action to address the issues.

Mr. Mounts is an associate attorney with Krieg DeVault LLP. His practice focuses on employee benefits and executive compensation law, including work on ESOP plans and related matters.

On April 12, 2011, Representative David Reichert (R—WA) introduced the S Corporation Modernization Act of 2011 on the House floor. The bill is cosponsored by Representative Ron Kind (D—WI). The bill contains a number of provisions that, like its name suggests, are aimed at updating some of the more draconian restrictions on S corporations. They include:

• Reduced Recognition Period for Built-In Gains: This provision would permanently reduce the built-in gains “recognition period” from ten years to five years. The built-in gains recognition period is the amount of time—beginning on the date of the company’s S election—that the built-in gains tax would apply to any built-in gains recognized from the sale of assets that were owned in pre-S corporation years. The built-in gains tax is only applicable to S corporations that have made a conversion from C corporation status.

• Repeal of Excessive Passive Investment Income as Termination Event: For taxable years beginning in 2011, S corporations would no longer be subject to the provision creating an involuntary termination event if an S corporation that has accumulated earnings and profits from C corporation years also has passive investment income exceeding 25 percent of gross receipts for three consecutive years. Presently, there is an exception to this rule that allows banks to exclude from passive investment income (1) interest income and (2) dividends on assets required to be held by the bank (e.g., Federal Reserve stock, Federal Home Loan Bank stock, etc.).

• Modification to Passive Income Rules: Section 1375 of the Internal Revenue Code imposes an additional tax on passive investment income if it exceeds 25 percent of gross receipts. This provision would amend this rule to increase that threshold up to 60 percent of gross receipts.

• Expansion of Beneficiaries of Electing Small Business Trust: This provision would allow non-resident aliens to qualify as beneficiaries of electing small business trusts (ESBTs). Presently, each beneficiary of an ESBT must separately qualify as an eligible S corporation shareholder. Non-resident aliens are not permissible S corporation shareholders.

• IRAs Included as Eligible S Corporation Shareholders: This provision would expand the scope of permissible S corporation shareholders to include all IRAs and Roth IRAs. Currently, IRAs and Roth IRAs may only own stock in S corporation banks and bank holding companies, and only to the extent that the stock was already owned on or before October 22, 2004.

• Allowance of Deduction for Charitable Contributions to ESBTs: This provision would expand the charitable deductions available to ESBTs.

• Basis Adjustment for Charitable Deductions of Property: This provision would make permanent a rule requiring a basis adjustment for contributions of property by an S corporation.

The legislation was referred to the House Ways and Means Committee on April 12th.

We will continue to track the progress of this bill and any developments will be promptly reported on our website at www.subsbanks.org.

Community banks continue to face significant headwinds and challenges to performance. Regulatory issues, weak loan growth, and an uncertain rate outlook are weighing heavily on margins and returns. As bank managers struggle with this environment, it is helpful to remember a few simple rules for prudent balance sheet management.

• Keep Assets Deployed – In the last two years, banks have experienced a substantial change in their asset mix, moving away from loans and into investments. Simultaneously, deposit growth has continued to be steady or strong at most banks. Average loan-to-deposit ratios for US banks are now lower than they’ve been in at least five years, and the trend may not reverse very soon. In the midst of this excess liquidity, banks should take care to keep assets productively deployed in order to avoid a drag on earnings. Over the past 24 months or so, large balances sitting in fed funds have amounted to a painful and mistaken bet on rising interest rates. It’s better to keep the balance sheet fully engaged and hitting on all cylinders rather than sitting on a large funds balance earning nearly nothing.

• Manage Cash Flow and Liquidity – It has always been our contention that managing interest rate risk in a bank balance sheet is largely a function of cash flow management. Traditionally, there is no better hedge against rising interest rates than a steady stream of predictable cash flow that can be redeployed into new, higher yielding assets. In terms of the investment portfolio, cash flow and the volatility of cash flow also determine such things as duration and convexity, key measures of price risk for bonds. In a very real sense, financial assets are simply streams of cash flow to be managed for optimal reward and acceptable risk.  Along those same lines, banks should always remember the role of the investment portfolio as a vehicle for managing liquidity. Proper identification of bonds and bond-types that provide reasonably consistent and predictable cash flow, as well as securities that are readily sold in the secondary market is critical. The risk/reward relationship for securities should be viewed with an eye toward liquidity risk. When purchasing a bond or considering alternatives, portfolio managers should take a hard look at the cash flow uncertainty or optionality as well as the underlying price sensitivity.

• Stay Sharply Focused on Municipal Credit – Bank managers must view the purchase of municipal bonds in the same way that they look at loans. Sound credit analysis is critical. This includes pre-purchase as well as ongoing access to available measures of risk and credit-worthiness. The Baker Group LP provides clients with thorough portfolio analytics and a reporting system which details credit metrics that are available for municipal bond issues. Among other things, this system provides hyperlinks to the original official statement of bonds as well as the most recently issued financial statements. Portfolio managers should have usable information that gives them comfort that the municipal issuer to whom they are lending money is an acceptable risk, and that they are being adequately compensated in terms of reward or yield.

• Don’t Reach for Yield – Bankers continue to operate in a historically unprecedented rate environment with excess liquidity and increasing margin pressures. This is when bankers can be tempted to reach for yield without adequate regard for the cost in terms of price or liquidity risk. In this kind of environment, there are many types and structures of bonds that show attractive nominal yields, but often they contain greater risk than is desired or acceptable. Be careful to think through the risks of long-maturity callable or step-up structures, for example. Now is when investment officers and portfolio managers should concentrate on high grade credit and reasonable returns, rather than high nominal yield and unreasonable options risk. Remember that often the highest “stated” yield does not produce the best all-in return. To use a baseball analogy, hit singles and doubles right now. Don’t swing for the fence.

The deadline for Subchapter S banks to apply for the Small Business Lending Fund (SBLF) has, as of this publication, come and gone. Now, many of the banks that submitted applications are trying to decide whether or not they really want to participate in the program. The SBLF is meant to spur small business lending by offering increasingly cheaper capital as community banks increase loan volume to qualifying small businesses. For some Sub S organizations, however, this cheap source of capital may not be quite as enticing as Congress and the Treasury Department may have hoped.

Similar to the now-infamous TARP Capital Purchase Program (CPP), under the SBLF, Sub S banks or bank holding companies will issue senior unsecured subordinated debentures to Treasury. Unlike the CPP, however, these subordinated debentures will not qualify for Tier 1 capital treatment. Presumably, the principal reason is because it conflicts with the Collins Amendment to the Dodd-Frank Act, which prohibits bank holding companies from having capital guidelines any less stringent than those for banks. And all term subordinated debt is treated as Tier 2 capital for banks.

    The Tier 2 capital treatment will likely discourage all but a handful of banks from taking SBLF funds. Small bank holding companies—bank holding companies with less than $500 million in consolidated total assets—are not subject to the Federal Reserve’s capital adequacy guidelines and, therefore, should be less concerned with the regulatory capital treatment. In addition, the Federal Reserve recently issued an interim final rule allowing Sub S bank holding companies to exclude SBLF funds from treatment as “debt” for purposes of the debt-to-equity standard under the Small Bank Holding Company Policy Statement. The debt-to-equity standard is .3 to 1.

SBLF funds may be used to redeem prior Treasury investments under the CPP or the Community Development Capital Initiative (CDCI). Additionally, there will generally be no restrictions on the payment of common dividends or stock repurchases so long as the issuer’s total risk-based capital would be at least 90% of the amount existing at the time of Treasury’s SBLF investment.

For small bank holding companies, or those less concerned about the Tier 2 capital treatment, SBLF funds can be a relatively inexpensive source of capital. As noted in the above table, the interest rate on the debentures can drop to as low as 1.5% for banks that increase small business lending by 10% or more.

One important consideration though, is that regardless of how much the bank increases its small business lending, after four and a half years, the rate automatically resets to 13.8%. Banks considering taking SBLF funds should plan for how they will pay off the debt before the rate jumps up. Aside from utilizing existing capital to pay off the note, options include refinancing as senior or subordinated debt or issuing additional shares of stock.

So far we have not heard of any Sub S banks receiving approval from Treasury yet. Once that happens, applicants will have a relatively short period of time within which to review and propose changes to the documents. Most likely, very little of the debentures will actually be negotiable; however, we do recommend reviewing the documents with counsel before closing the transaction.

Mr. Toppin is a partner with the law firm of Kennedy, Toppin & Sutherland, LLP, specializing in counseling community banks on corporate, banking, regulatory, lending and securities matters. He is also the Executive Director of the Subchapter S Bank Association. He can be reached by email at btoppin@ktsllp.com or by phone at (210) 228-4414.