The National Credit Union Administration (“NCUA”) has issued an Advanced Notice of Proposed Rulemaking (the “Rulemaking”) addressing the use of alternative capital for federally insured credit unions (“FICUs”). Alternative capital consists of secondary capital and supplemental capital. Currently, only low income credit unions (“LICU”) can issue secondary capital. At the NCUA’s October 2016 board meeting, senior staff of the NCUA presented the NCUA Board (the “Board”) with a presentation of the issues concerning the use of supplemental capital by all FICUs. The Rulemaking that has followed is the first step in authorizing supplemental capital for all FICUs. The NCUA originally requested comment on supplemental capital during its risk-based capital rule making and is now soliciting further public comment in a number of areas. The comment period closes on May 9, 2017.
Supplemental capital does not provide any capital support under the NCUA’s net worth requirement because it does not count as equity under generally accepted accounting principles. Secondary capital, however, can count toward the LICU’s net worth requirement even though it is a form of debt. Supplemental capital, however, would allow FICUs to have a greater concentration of member business loans and long term mortgage loans since it could be used to meet the requirements under the NCUA’s risk-based capital requirement, which becomes effective on January 1, 2019. To be well capitalized under this requirement a FICU must maintain a 10% risk-based capital ratio in addition to its net worth requirement of 7%. The rule only applies to “complex” credit unions (those with assets over $100 million).
Unlike banking institutions, credit unions cannot issue stock to raise equity capital. Under current law, LICUs can raise secondary capital (a form of subordinated debt) by issuing such capital to non-natural persons (e.g., institutional investors). The NCUA has noted, however, that only a small percentage of LICUs (about 3% as of June 30, 2016) have issued secondary capital. As a result of the inability to raise supplemental capital, a number of credit unions have converted to mutual savings banks as a first step in ultimately issuing stock as a means of raising capital to grow the institution. As the regulatory burden and operating costs continue to increase for all institutions, access to capital is a critical tool. Under current regulations, a secondary capital plan must be filed with, and approved by, the NCUA prior to issuance of secondary capital. The secondary capital must be unsecured and be subordinated to all other claims of the credit union (including supplemental capital). It must have a minimum maturity of five years and beginning with the fifth year prior to maturity the amount includable is reduced by 20% a year. Secondary capital instruments must absorb loses on a pro-rata basis. The form of supplemental capital envisioned by the NCUA would be on similar terms. Different classes of supplemental capital could be created, however, such that one class might be subordinated to another class.
Current Use of Secondary Capital
Credit Unions. At June 30, 2016, only 73 LICUs (out of 2,426 LICUs) had outstanding secondary capital in the principal amount of $181 million or 13% of the total net worth of LICUs. Four LICUs held 74% of the secondary capital outstanding. The interest rate paid by the four largest issuers ranged from 0.14% to 3.5%. The NCUA also noted that the failure ratio of LICUs that issued secondary capital was higher than those that did not. It is not clear as to why so few LICUs have utilized secondary capital. Clearly, the cost of subordinated debt is higher than the cost of deposits, FHLB borrowings or common stock so unless the institution has a business plan to grow the balance sheet with higher yielding loans, such as MBLs, the issuance of subordinated debt may not make good business sense. The NCUA noted that the estimated number of non-LICUs that might issue supplemental capital is 140 with a potential aggregate issuance of $9.2 billion. This is based upon a category of non-LICUs with a net worth ratio greater than 8% and an estimated risk-based ratio of less than 13.5%. The aggregate amount needed for these 140 institutions to reach 13.5% would be $1 billion. The actual pool may be higher or lower depending upon a credit union’s growth plans.
Banks. The NCUA noted that the amount of subordinated debt issued by community banks increased in 2016. As of June 30, 2016, the amount outstanding was $831 million, which was 0.34% of total community bank capital and an increase of $352 million from December 31, 2015. Generally the interest rate was 300 to 400 basis points over the ten year Treasury note. Most buyers were pension funds, mutual funds and high net worth investors. The NCUA did not provide any information about the size of the institutions that issued subordinated debt or the size of the offerings. Investment banking fees, as noted by the NCUA, ranged from 125 basis points to 300 basis points, and typically decrease with the size of the offering. It is quite possible that the interest rates for credit unions would be higher since they are unable to raise capital in the event of financial difficulty as a means of addressing the debt service of the supplemental capital.
Authority to Issue Supplemental Capital
The authority of LICUs to issue secondary capital is authorized under the Federal Credit Union Act. The NCUA concluded that all federal credit unions would have the authority to issue supplemental capital under their general borrowing authority. As for state chartered credit unions, the authority would need to be based on state law which could vary from state to state.
Limit on the Amount of Supplemental Capital
Under current regulations there is no express limit on the amount of secondary capital that can be counted as regulatory capital by LICUs. Under the federal banking regulations, the amount of Tier 2 capital, which includes subordinated debt, cannot exceed 50% of Tier 1 capital (which includes common stock) for meeting the total capital requirement applicable to banks. The NCUA seeks comment on, among other things, what limits should apply to the amount of supplemental capital that may be included for the risk-based capital requirement; the reduction of the amount included during the last five years of the life of the instrument; and early repayment options. It is likely that the NCUA will look to the federal banking regulations for guidance on this issue.
The NCUA noted that both secondary and supplemental capital securities would be considered securities under federal and state law. As a security under federal and state law, the issuer of such capital would be required to comply with the federal securities laws and state securities laws unless an exemption is utilized. The security itself would be exempted from registration with the Securities and Exchange Commission (“SEC”) under federal law since it is issued by a credit union (a similar exemption exists for banks). The other exemption would involve the nature of the offering, rather than the security. Under federal law the most widely used exemption is the “private placement” (a “Regulation D offering”) whereby securities are offered to institutional investors or a limited group of investors (“accredited investors”). State laws may vary, but most states provide an exemption for offerings that comply with Regulation D.
Any offering of the securities by a credit union would still be subject to the anti-fraud provisions of the Federal Securities Act and Rule 10b-5 of the SEC. In the absence of SEC mandated disclosures, the NCUA is soliciting comment on what type of disclosure should be required to meet the anti-fraud standard under federal law. In that regard the NCUA noted that the Office of the Comptroller of the Currency (the “OCC”), which regulates national banks and federal savings banks, has mandated disclosures that are similar to those required by the SEC and requires that such institutions register the securities with the SEC before issuance unless an exemption is available.
In the event that the NCUA permits secondary or supplemental capital securities to be issued to individuals (including the general public), in other than a private placement, a prospectus containing extensive financial information about the credit union would be required as well as annual and quarterly reports (e.g., 10-K, 10-Q). The NCUA would act in place of the SEC in reviewing such documents. If the debt is offered for sale within the branches, issuers would need to ensure it would not be confused with an insured deposit, such as a certificate of deposit.
The NCUA seeks comment: (1) on whether the securities should be registered with the NCUA, (2) the level of disclosures that should be required, and (3) should the level of disclosure vary depending upon the nature of the investor (institutional, natural person, etc.). In light of the uninsured nature of the securities, adequate disclosure modeled after the SEC and OCC rules should be required to protect the investors and shield the credit union from any securities fraud claim, as well as reputational risk.
Under current NCUA regulations, secondary capital can only be purchased by non-natural persons. The NCUA has requested comment on whether both secondary capital and supplemental capital should be made available to other than institutional investors, including accredited investors and the general public. Clearly, to make the best use of these capital instruments, the NCUA should allow it to be purchased by members of the credit union and the general public. Assuming sufficient investor protection is provided in the form of appropriate disclosure (such as in the case of SEC mandated disclosures), there should be no reason to limit the scope of the investors. Allowing non-members to participate should not raise any concern regarding the mutual ownership structure and governance of credit unions provided adequate measures are contained in the terms of the offering to address this issue.
Clearly, there is a cost to issuing secondary or supplemental capital, particularly in a public offering. These costs can vary depending upon the size of the issuance, and include legal, investment banking, accounting and ongoing regulatory compliance. Attorneys, accountants and financial advisors would be part of the team assisting the credit union. In a public offering, the NCUA would have jurisdiction in lieu of the SEC, in much the same way that bank regulators replace the SEC in bank offerings. One method of addressing the cost issue and to allow smaller credit unions to participate and raise capital in incremental pieces is through the use of pooled offerings. In a pooled offering a group of credit unions share the costs of the issuance. For example, a pooled offering of $100 million might have 10 credit unions participating in the offering, each having a certain piece of the pool. The pooled offering concept was used by community banks in the early 2000’s to raise equity capital. These capital instruments, known as trust preferred securities, also allowed the institutions to take a take tax deduction for the interest paid on the securities. This concept would be adaptable to credit unions. A pooled offering would likely also provide the prospect for obtaining an investment rating by a rating agency thereby facilitating a lower rate of interest.