Uninsured Secondary Capital, 4234-4240 [06-686]

Agencies

• National Credit Union Administration

[Federal Register Volume 71, Number 17 (Thursday, January 26, 2006)]
[Rules and Regulations]
[Pages 4234-4240]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-686]


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NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 701 and 741


Uninsured Secondary Capital

AGENCY: National Credit Union Administration (NCUA).

ACTION: Final rule.

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SUMMARY: The National Credit Union Administration (NCUA) is adopting 
modifications to its rules on uninsured secondary capital accounts to 
allow low-income designated credit unions to begin redeeming the funds 
in those accounts when they are within five years of maturity, and to 
require prior approval of a plan for the use of uninsured secondary 
capital before a credit union can begin accepting the funds.

DATES: This rule is effective February 27, 2006.

FOR FURTHER INFORMATION CONTACT: Steven W. Widerman, Trial Attorney, 
Office of General Counsel, at 703/518-6557; or Margaret Miller, Program 
Officer, Office of Examination and Insurance, at 703/518-6375.

SUPPLEMENTARY INFORMATION:

A. Background

    1. Uninsured secondary capital accounts. Under conditions 
prescribed by the NCUA Board, credit unions serving predominantly low-
income members are permitted by law to receive payments on shares from 
non-natural persons. 12 U.S.C. 1757(6). In 1996, the NCUA Board 
authorized low-income designated credit unions (``LICUs''),\1\ 
including State-chartered credit unions to the extent permitted by 
State law, to accept uninsured secondary capital (``USC'') from non-
natural person members and nonmembers. 12 CFR 701.34(b) (2005). The 
purpose of USC is to provide a further means--beyond setting aside a 
portion of earnings--for LICUs to build capital to support greater 
lending and financial services in their communities, and to absorb 
losses and thus protect LICUs from failing. 61 FR 3788 (Feb. 2, 1996); 
61 FR 50696 (Sept 27, 1996).
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    \1\ The NCUA Board is authorized by law to define ``credit 
unions serving predominantly low-income members.'' 12 U.S.C. 
1757(6). To be so designated by the appropriate Regional Director, 
the NCUA Board generally requires the majority of a credit union's 
members to earn less than 80 percent of the average national wage as 
determined by the Bureau of Labor Statistics, or to have annual 
household incomes below 80 percent of the national median as 
determined by the Census Bureau. 12 CFR 701.34(a)(2)-(3).
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    To ensure the safety and soundness of LICUs that accept USC, the 
existing rule imposed multiple restrictions that also apply to State-
chartered LICUs. 12 CFR 741.204. Before accepting USC, a LICU must 
submit a written plan for the use and repayment of USC. Sec.  
701.34(b)(1). USC accounts must have a minimum maturity of five years 
and may not be redeemable prior to maturity. Sec.  701.34(b)(3)-(4). 
The accounts must be established as uninsured, non-share instruments. 
Sec.  701.34(b)(2) and (5). And most importantly, USC funds on deposit 
(including interest paid into the account) must be available to cover 
operating losses in excess of the LICU's net available reserves and 
undivided earnings. Sec.  701.34(b)(7). Funds used to cover such losses 
may not be replenished or restored to the USC accounts. Id.
    2. Impact of Prompt Corrective Action. Since the inception of USC, 
existing Sec.  701.34(c)(1) has required LICUs to discount a USC 
account's original capital value (now called ``net worth value'')--
essentially recategorizing the discounted portion as subordinated 
debt--in 20 percent annual increments beginning at five years remaining 
maturity. Even as its capital value is discounted, however, the full 
amount of USC must remain on deposit to cover losses. Sec.  
701.34(c)(2) (2005).
    In 2000, pursuant to Congressional mandate, NCUA adopted a system 
of ``prompt corrective action'' (``PCA'') consisting of mandatory 
minimum capital standards indexed by a credit union's ``net worth 
ratio'' to five statutory net worth categories.\2\ 12 U.S.C. 1790d; 12 
CFR part 702; 65 FR 8560 (Feb. 18, 2000). As a credit union's net worth 
ratio falls, its classification among the net worth categories declines 
below ``well capitalized,'' thus exposing it to an expanding range of 
mandatory and discretionary supervisory actions

[[Page 4235]]

designed to restore net worth. E.g., 12 CFR 702.201(a), 702.202(a), 
702.204(b).
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    \2\ The ``net worth'' of a LICU is defined by law as its 
retained earnings under GAAP plus any USC on deposit. 12 U.S.C. 
1790d(o)(2); 12 CFR 702.2(f). The ``net worth ratio'' of a credit 
union is the ratio of its net worth to its total assets. 12 U.S.C. 
1790d(o)(3); 12 CFR 702.2(g) and (k).
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    Because of PCA, discounting the net worth value of USC beginning at 
five years remaining maturity reduces a LICU's net worth ratio. While 
the ``net worth'' numerator of the ratio is reduced at the rate of 20 
percent annually, the ``assets'' denominator must remain the same 
because of the existing rule's restriction on redeeming USC accounts 
prior to maturity. Sec.  701.34(b)(4) (2005). The result is that 
discounting the net worth value of USC dilutes a LICU's net worth 
ratio, threatening to lower its classification among the PCA net worth 
categories.
    3. 2005 Proposed Rule. December 2004 Call Report data indicated 
that a significant number of LICUs are exposed to the risk that 
discounting the value of their USC will dilute their net worth ratio. 
70 FR 43789 (July 29, 2005).\3\ For this reason, the NCUA Board issued 
a proposed rule allowing low-income designated credit unions that have 
USC accounts to begin redeeming the funds in those accounts when they 
are within five years of maturity. 70 FR 43789. To discourage the 
misuse of USC, the proposed rule also requires prior approval, not just 
submission, of a plan for the use and repayment of the aggregate USC 
before a LICU can accept USC accounts. Id.
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    \3\ June 2005 data shows that 55 LICUs have USC accounts. These 
accounts have an aggregate balance of $30 million in USC. Of these 
LICUs, 46 are classified ``well capitalized'' and 4 are classified 
``adequately capitalized,'' indicating that 89 percent currently 
have net worth ratios that subject them to little or no PCA.
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    NCUA received four comments in response to the proposed rule, all 
from credit union industry trade associations representing different 
segments of the industry. One commenter supported without reservation 
the proposal to allow redemption of USC accounts prior to maturity; the 
other three supported the proposal subject to their comments discussed 
below. One commenter supported without reservation the proposal to 
require prior approval of a plan for the use and repayment of USC; the 
other three opposed the requirement altogether for reasons given in 
their comments discussed below. Suggested revisions to the existing 
regulation beyond those introduced in the proposed rule also are 
addressed below.

B. Analysis of Comments on Proposed Rule

1. Redemption of Secondary Capital Prior to Maturity

    To protect a LICU's net worth ratio from being diluted by 
discounting the net worth value of its USC, the proposed rule 
introduced new subsection (d) eliminating the existing bar against 
redemption and, instead, prescribing conditions under which LICU's may 
redeem discounted USC prior to maturity.
    Prepayment Risk. Two commenters noted that the proposed rule fails 
to address the ``prepayment risk'' for account investors created by 
permitting LICUs to redeem USC prior to maturity, and also does not 
disclose that risk in the ``Disclosure & Acknowledgement'' form in the 
Appendix to Sec.  701.34. ``Prepayment risk'' is the risk that, to the 
extent USC is repaid earlier than the final maturity date, the account 
investor may be deprived of expected interest income because it will be 
unable to reinvest the repaid funds at the same rate of interest for 
the balance of the period remaining until the original maturity date. 
This risk represents a legitimate concern. USC investors can protect 
themselves from prepayment risk to the extent they contract with the 
LICU to limit or bar redemption prior to maturity of the investor's 
account. To the extent the parties are silent about redemption prior to 
maturity, the ``Disclosure and Acknowledgement'' in Appendix A to Sec.  
701.34 is amended to put the investor on notice as follows:

    4. Prepayment and other risks. Redemption of USC prior to the 
account's original maturity date may expose the account investor to 
the risk of being unable to reinvest the repaid funds at the same 
rate of interest for the balance of the period remaining until the 
original maturity date. The investor acknowledges that it 
understands and assumes responsibility for prepayment risk 
associated with [name of credit union]'s redemption of the 
investor's USC account prior to the original maturity date.''

    Redemption in Final Year Prior to Maturity. The new schedule for 
redeeming USC does not provide for redemption of the last twenty 
percent increment of discounted USC during the final year prior to 
maturity. Sec.  701.34(d)(3). As the proposed rule explained, this last 
increment of discounted USC will be redeemed at the account's final 
maturity date. 70 FR at 43790. Two commenters asked why LICUs are not 
allowed to redeem the last increment of discounted USC during the final 
year, i.e., before the account's final maturity date. The reason is 
that, to fulfill its most important purpose, the final twenty percent 
increment must remain available to cover operating losses until the 
final maturity date, even as its net worth value is discounted to zero. 
Sec.  701.34(c)(2). If LICUs were permitted to redeem the last twenty 
percent increment before the account's maturity, there would be no USC 
on deposit to cover post-redemption operating losses arising prior to 
the final maturity date. Thus, the final rule retains the new schedule 
for redemption as proposed. Sec.  701.34(d)(3).
    Minimum post-redemption net worth classification. To redeem 
discounted USC, the proposed rule required a LICU to have a post-
redemption net worth classification of ``well capitalized.'' 70 FR at 
43790. However, a credit union that would be ``adequately capitalized'' 
after redeeming discounted USC could apply on a case-by-case basis for 
Regional Director approval to redeem. Id. It is apparent upon 
reconsideration that this requirement for ``adequately capitalized'' 
credit unions is redundant because each credit union's request to 
redeem, regardless of post-redemption net worth, already receives 
subjective, case-by-case evaluation and approval. Moreover, the post-
redemption difference between a ``well capitalized'' and an 
``adequately capitalized'' credit union is that PCA subjects the latter 
to a single ``mandatory supervisory action'': The requirement to make 
quarterly contributions of earnings to build net worth.
    One commenter asked why the proposed rule did not allow a LICU to 
redeem discounted USC if its post-redemption net worth classification 
would be less than ``adequately capitalized'' (i.e., a net worth ratio 
of 5.99 percent or less). There are three reasons for setting a minimum 
post-redemption net worth ``floor'' at ``adequately capitalized.'' 
First, very few LICUs would be affected because typically only a 
handful (five or less as of June 2005) would have a net worth 
classification of less than ``adequately capitalized'' after redeeming 
their discounted USC. Second, among all LICUs that accept USC, 
redeeming discounted USC would rarely increase one's net worth ratio 
significantly enough to raise a LICU to a higher net worth category. 
And third, on rare occasions when redemption would raise a LICU to a 
higher category, as long as it still is below ``adequately 
capitalized,'' the LICU would remain burdened with the full range of 
``mandatory supervisory actions'' that PCA imposes on the bottom three 
net worth categories.\4\ Prohibiting

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redemption by credit unions that remain in these categories furthers 
the goal of maximizing their cushion against operating losses that 
otherwise would be borne by the Share Insurance Fund.
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    \4\ In addition to making quarterly transfers of earnings to 
build net worth, credit unions in the ``undercapitalized,'' 
``significantly undercapitalized'' and ``critically 
undercapitalized'' net worth categories must comply with three 
further ``mandatory supervisory actions'': (1) A freeze on total 
assets; (2) a freeze on the balance of MBLs; and (3) the requirement 
to submit a net worth restoration plan for approval. 12 U.S.C. 
1790d(f)-(g); 12 CFR 702.202(a).
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    For these reasons, the final rule retains ``adequately 
capitalized'' as the minimum post-redemption net worth ``floor'' for 
redeeming discounted USC.
    Resolution Authorizing Redemption. The proposed rule requires that 
a LICU's request to redeem USC be authorized by a resolution of the 
credit union's board of directors. 70 FR at 43790. The rule explained 
that the purpose of a board resolution is to ``document[] that a 
majority of the board participated in a board decision. Maximum board 
member participation in deciding to redeem SC helps to overcome 
possible conflicts of interest between LICU officials and officials of 
the SC account holder.'' Id. A commenter asks either that this 
rationale be further explained, or that the resolution requirement be 
eliminated from the final rule.
    The final rule retains the resolution requirement as proposed, but 
further explains its purpose as follows. In many instances, a LICU in 
search of USC and potential USC investors are identified and brought 
together by one or more individual officials of each party to the 
transaction. These individuals sometimes have pre-existing familial or 
business relationships that may impair their independence and fidelity 
to the interests of the party they represent. On the assumption that 
the credit union official who was the ``finder'' of the USC investor is 
singularly able to consummate the transaction, the natural tendency of 
credit union officials is to defer to that person's knowledge and 
judgment. Excessive reliance on knowledge and judgment concentrated in 
one or a few individuals allows them to be unduly influential in the 
making of decisions relating to the transaction.
    In the case of USC investments, the dominant influence of the 
``finder(s)'' may extend to deciding whether to accommodate an 
investor's wish to redeem its USC account at the earliest opportunity, 
thus realizing a prepayment award (through reinvestment at more 
favorable interest rate), or to forestall redemption to avoid 
prepayment risk (requiring reinvestment at a less favorable interest 
rate). A resolution of a credit union's board of directors would ensure 
that such a decision is made by the board as a whole, is consistent 
with the credit union's best interests, and is transparent. For these 
reasons, the final rule requires that a LICU's request to redeem 
discounted USC be embodied in a duly authorized resolution of its board 
of directors.
    Timing and scope of request to redeem. The proposed rule provided 
that ``a request to redeem discounted secondary capital must be 
submitted in writing on an annual basis.'' Sec.  701.34(d)(1). The 
preamble explained that a request ``must be submitted for each year 
preceding maturity (unless the Regional Director indicates in writing 
that the approval is for more than one year).'' 70 FR at 43790. A 
commenter asks if this means that a redemption request may be submitted 
only once a year, thus precluding more than one request per year. The 
answer is no.
    To ensure that redemption requests may be submitted at any time and 
may be broadly framed, the final rule is revised to allow a request to 
be submitted ``at any time'' so long as it ``specif[ies] the 
increment(s) to be redeemed and the schedule for redeeming all or any 
part of each eligible increment.'' As a result, LICUs will have the 
option to, for example, seek approval extending beyond the current 
year, thus allowing future years' increments of discounted USC to be 
redeemed as they become eligible; or to redeem a year's increment in 
installments timed to correspond with the availability of liquidity 
from maturing instruments and availability of sources of lower cost 
funds. Finally, to give Regional Directors maximum flexibility in 
addressing redemption requests that may be ambitious in scope, the 
final rule has been revised to provide that: ``A request to redeem 
discounted secondary capital may be granted in whole or in part.''

2. Pre-Approval of Plan for Use of Uninsured Secondary Capital

    Existing Sec.  701.34(b) requires a LICU that is planning to accept 
USC accounts to forward to the appropriate Regional Director (and to 
the appropriate State Supervisory Authority (``SSA'') in the case of 
State-chartered LICU) a written plan for the use of the aggregate funds 
in those accounts and ``subsequent liquidity needs'' to repay them upon 
maturity (``Plan''). Sec.  701.34(b)(1); 12 CFR 741.204(c). No Regional 
Director or SSA approval is required. In contrast, the proposed rule 
requires prior regulatory approval of a USC Plan, subject to certain 
matters the Plan must address, before USC accounts can be accepted.\5\ 
Sec.  701.34(b). As proposed, a USC Plan need not be submitted for each 
account individually; rather it may address the maximum aggregate USC 
that a LICU expects to receive.
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    \5\ Approval will be required oly for USC Plans submitted on or 
after the effective date of this final rule; Plans submitted before 
that date will not be affected. However, no USC Plan is necessary 
for funds received after the effective date pursuant to a Plan 
adopted and submitted before the effective date.
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    Misuse of Secondary Capital. A principal reason for requiring 
approval--not just submission--of a LICU's USC Plan is to ensure that 
USC is used to achieve the goals for which it was conceived, i.e. 
building capital to support expansion of lending and financial services 
in LICUs' communities, and to serve as a cushion against losses. 61 FR 
3788 (Feb. 2, 1996). Emphasizing that USC is disclosed in a LICU's 
quarterly Call Report, three commenters questioned the proposed rule's 
conclusion that ``SC played a role in masking the magnitude of other 
problems'' that caused LICUs to fail. 70 FR at 43791. One assumed that 
those cases ``undoubtedly involved fraud and/or major recordkeeping 
deficiencies'' and thus were atypical. Two commenters contended that 
requiring prior approval of USC Plans would not improve safety and 
soundness enough to justify the additional burden on credit unions. And 
the third objected that that burden creates an additional step that 
could discourage potential investors from entering the USC market.
    Net worth is a reliable--if sometimes lagging--indicator of 
operational problems and poor financial performance that threaten a 
credit union's solvency. Full disclosure of a LICU's USC balance 
distinguishes the portion of net worth derived from earnings generated 
by routine credit union operations, in contrast to the portion derived 
from subordinated debt that ultimately must be repaid. However, this 
quantitative distinction tells us nothing about a LICU's qualitative 
use of USC, which in terms of risk to credit union safety and 
soundness, can range from negligible to perilous.
    Contrary to a commenter's assumption, the problems that the final 
rule addresses generally are not solely the result of fraud and 
deficient recordkeeping. Rather, they reflect an emerging pattern of 
lenient practices that frustrate LICUs' good faith use of USC. These 
practices include: (1) Poor due diligence and strategic planning in 
connection with establishing and expanding member service programs such 
as ATMs, share drafts and lending (e.g., member business loans 
(``MBLs'') real estate and subprime); (2) Failure to

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adequately perform a prospective cost/benefit analysis of these 
programs to assess such factors as market demand and economies of 
scale; (3) Premature and excessively ambitious concentrations of USC to 
support unproven or poorly performing programs; and (4) Failure to 
realistically assess and timely curtail programs that, in the face of 
mounting losses, are not meeting expectations. When they occur, these 
lenient practices contribute to excessive net operating costs, high 
losses from loan defaults, and a shortfall in revenues (due to non-
performing loans and poorly performing programs)--all of which, in 
turn, produce lower than expected returns.
    Promoting diligent practices in place of lenient ones cannot help 
but improve the safety and soundness of LICUs. Requiring prior approval 
of a USC Plan will strengthen supervisory oversight and detection of 
lenient practices in several ways. First, it will prevent LICUs from 
accepting and using USC for purposes and in amounts that are improper 
or unsound. Second, the approval requirement will ensure that USC Plans 
are evaluated and critiqued by the Region before being implemented. 
Third, for both NCUA and the LICU, an approved USC Plan will document 
parameters to guide the proper implementation of USC, and to measure 
the LICU's progress and performance. For these reasons, the final rule 
requires prior Regional Director approval of a USC Plan.
    Finally, to the extent that obtaining prior approval adds a step 
that might cause undue delay, possibly discouraging potential investors 
from entering the USC market, the final rule provides a backstop. A 
Regional Director has 45 days from the date a USC Plan is submitted to 
approve or disapprove it. However, the final rule provides that if a 
Regional director fails to act on a USC Plan within that period, the 
Plan is approved by default and ``the LICU may proceed to accept 
secondary capital accounts pursuant to the plan.'' Sec.  701.34(b)(2).
    Regional Director discretion to approve Plan. Before accepting USC 
accounts, the proposed rule required a LICU to forward its USC Plan to 
the appropriate NCUA Regional Director for approval. Sec.  
701.34(b)(1). One commenter objected that this approval authority 
``places excessive discretion in the hands of the agency's regional 
directors.'' The NCUA Board believes the degree of Regional Director 
discretion is appropriate for two reasons. First, because the final 
rule establishes four criteria on which a decision to approve or 
disapprove must be based: how the LICU will USC in the aggregate; how 
it will provide for subsequent liquidity to repay the accounts; whether 
the use of USC conforms to the LICU's strategic plan, business plan and 
budget; and whether the Plan is supported by two years of pro forma 
financial statements. And second, in assessing those criteria, the 
Regional Director will be relying on input from the examiner who 
regularly oversees the credit union and, thus, is well-suited to judge 
its capabilities. For these reasons, the NCUA Board is content to give 
its Regional Directors the authority to take final agency action on USC 
Plans. Accordingly, the final rule retains as proposed the requirement 
for Regional Director prior approval of USC Plans.
    Pro forma financial statements. To the existing criteria for 
approval of a Plan, the proposed rule adds the requirement to 
demonstrate that the intended use of USC conforms to the accepting 
LICU's strategic plan, business plan and budget; and is supported by 
accompanying pro forma financial statements, including any off-balance 
sheet items, covering a minimum of the next two years. Sec.  
701.34(b)(1)(iv). As the proposed rule noted, the purpose of this 
criterion ``is to project and document the future financial performance 
of the LICU in relation to the risks associated with accepting USC 
accounts.'' 70 FR at 43791. Nonetheless, the single commenter who 
addressed this requirement objected, without explanation, that it is 
``unnecessary'' for a USC Plan to be supported and accompanied by pro 
forma financial statements. NCUA maintains that pro forma financial 
statements are a routine, yet essential, tool for documenting and 
testing the soundness of the assumptions a credit union relies on to 
project future performance. Pro forma financial statements benefit 
credit union management by measuring differences between planned and 
actual performance. And pro forma financial statements facilitate 
regulatory evaluation and supervisory oversight of USC Plans.

3. Other Comments

    The commenters suggested several revisions to the existing Sec.  
701.34(b) beyond those introduced in the proposed rule.
    Use of Secondary Capital to Pay Dividends. In both the existing and 
the proposed rule, the essential feature of USC is that it ``must be 
available to cover operating losses realized by the credit union'' in 
excess of its net worth. Sec.  701.34(b)(7). Two commenters advocate 
revising the final rule to clarify whether the payment of dividends is 
within or beyond the scope of ``operating losses realized by the credit 
union.'' Most contend that it is beyond the scope and thus should not 
be subsidized by USC.
    The Federal Credit Union Act addresses this issue by allowing a 
credit union's board of directors to declare a dividend only ``after 
provision for required reserves.'' 12 U.S.C. 1763; see also 12 U.S.C. 
1761b(18). The prerequisite to have reserves from which to fund 
dividends means that USC cannot be used to create reserves for that 
purpose where none exists. Thus, a credit union may declare dividends 
only to the extent it has reserves available. After fully posting and 
measuring net income, including completing provisioning for Allowance 
for Loan and Lease Losses and measuring it against net income, a credit 
union may declare and pay dividends only to the extent that it has 
reserves and undivided earnings exclusive of USC. The final rule 
revises the ``Disclosure and Acknowledgement'' form in the Appendix to 
Sec.  701.34 to clearly establish that ``Dividends are not considered 
operating losses and thus are not eligible to be paid out of secondary 
capital.''
    Replenishment of Secondary Capital Account. Both the existing and 
the proposed rule state that, to the extent an USC account is used to 
cover ``operating losses,'' the LICU ``shall under no circumstances 
restore or replenish the account.'' Sec.  701.34(b)(7) (2005). Two 
commenters believe that this restriction should be withdrawn so that a 
LICU could replenish USC accounts should it subsequently regain 
financial health. To do so would be inconsistent with the purpose of 
USC accounts, as explained in the final rule that first established the 
accounts: ``Permitting LICUs to replenish SC once financial health has 
been regained would defeat the purpose for establishing secondary 
capital. The goal of secondary capital is to enhance capital positions. 
The potential growth of primary capital could be slowed by allowing 
LICUs to replenish investor funds in the event those funds are 
depleted. Additionally, permitting replenishment could be interpreted 
as ``guaranteed return of principal'' by the investor which was not the 
Board's original intent.'' 61 FR at 50696. For these reasons, the final 
rule retains the restriction against restoring or replenishing USC 
accounts. Sec.  701.34(b)(7).
    Suspension of Dividend and Interest Payments. The proposed rule 
combines two subsections of the existing rule into a single, 
abbreviated section explaining

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NCUA's authority to suspend ``critically undercapitalized'' LICUs from 
paying principal, interest and dividends on USC accounts established 
after August 7, 2000, the date PCA became effective. Sec.  701.34(12). 
The sole commenter on this section advocated repealing this authority. 
Because it is indirectly prescribed by law for ``critically 
undercapitalized'' credit unions,\6\ the authority to suspend payments 
of principal, interest and dividends on USC accounts is not subject to 
repeal through the rulemaking process. Like the existing rule, the 
proposed subsection simply puts USC investors on notice of the 
possibility of a suspension of such payments in the event the LICU 
becomes ``critically undercapitalized.'' It is therefore retained as 
proposed. Sec.  701.34(b)(12).
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    \6\ Congress directed NCUA to make the system of PCA developed 
for insured credit unions ``comparable'' with the 1991 law (12 
U.S.C. 1831o) that mandated PCA for all other federally-insured 
depository institutions. 12 U.S.C. 1790d(b)(1)(A)(ii). That law 
authorized the Federal banking agencies to prohibit payments of 
principal or interest on a ``critically undercapitalized'' 
institution's subordinated debt. 12 U.S.C. 1831o(h)(2)(A). The 
Federal Deposit Insurance Corporation rule implementing that 
authority, for example, makes the prohibition mandatory. 12 CFR 
325.105(a)(4)(H). To be comparable with Sec.  1831o(h)(2)(A) as 
Congress instructed, part 702 established a ``discretionary 
supervisory action'' allowing, but not requiring, NCUA to ``prohibit 
payents of principal, dividends or interest on the credit union's 
uninsured secondary capital accounts * * *, excpet that unpaid 
dividends or interest shall continue to accure under the terms of 
the account * * *.'' 12 CFR 702.204(b)(11). See 64 FR 27090, 27098 
(May 18, 1999); 65 FR 8560, 8674 (Feb. 18, 2000). Section 701.34(b) 
was amended in 2000 to reflect the addition of this ``discretionary 
supervisory authority.'' 65 FR 21129 (April 20, 2000).
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Regulatory Procedures

Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA) requires NCUA to prepare an 
analysis describing any significant economic impact a proposed 
regulation may have on a substantial number of small credit unions. 
NCUA considers credit unions having less than ten million dollars 
($10,000,000) to be small for purposes of the RFA. The final rule 
allows credit unions to begin redeeming USC accounts when they are 
within five years of maturity, and requires them to obtain prior 
approval of a plan for the use and repayment of USC, without imposing 
any additional regulatory burden. The final rule will not have a 
significant economic impact on a substantial number of small credit 
unions. Thus, a Regulatory Flexibility Analysis is not required.

Paperwork Reduction Act

    NCUA has determined that the final rule would not increase 
paperwork requirements under the Paperwork Reduction Act of 1995 and 
regulations of the Office of Management and Budget. NCUA currently has 
OMB clearance for the collection requirements in Sec.  701.34 and part 
741 (OMB Nos. 3133-0140, 3133-0099, 3133-142 and 3133-163).

Executive Order 13132

    Executive Order 13132 encourages independent regulatory agencies to 
consider the impact of their regulatory actions on State and local 
interests. NCUA, an independent regulatory agency as defined in 44 
U.S.C. 3502(5), voluntarily adheres to the fundamental federalism 
principles addressed by the executive order. This final rule would not 
have a substantial direct effect on the States, on the relationship 
between the national government and the States, or on the distribution 
of power and responsibilities among the various levels of government. 
Accordingly, this final rule does not constitute a policy that has 
federalism implications for purposes of the Executive Order.

Small Business Regulatory Enforcement Fairness Act

    The Small Business Regulatory Enforcement Fairness Act of 1996 
(Pub. L. 104-121) provides generally for congressional review of agency 
rules. A reporting requirement is triggered in instances where NCUA 
issues a final rule as defined by Section 551 of the Administrative 
Procedures Act. 5 U.S.C. 551. NCUA submitted the rule to the Office of 
Management and Budget, which has determined that it is not major for 
purposes of the Small Business Regulatory Enforcement Fairness Act of 
1996.

Treasury and General Government Appropriations Act, 1999

    NCUA has determined that the proposed rule will not affect family 
well-being within the meaning of section 654 of the Treasury and 
General Appropriations Act, 1999, Pub. L. 105-277, 112 Stat. 2681 
(1998).

List of Subjects in 12 CFR Parts 701 and 741

    Bank deposit insurance, Credit Unions, Reporting and recordkeeping 
requirements.

    By the National Credit Union Administration Board on January 19, 
2006.
Mary F. Rupp,
Secretary of the Board.

0
For the reasons set forth above, 12 CFR parts 701 and 741 are amended 
as follows:

PART 701--ORGANIZATION AND OPERATIONS OF FEDERAL CREDIT UNIONS

0
1. The authority citation for part 701 continues to read as follows:

    Authority: 12 U.S.C. 1752(5), 1755, 1756, 1757, 1759, 1761a, 
1761b, 1766, 1767, 1782, 1784, 1787, 1789 and Public Law 101-73. 
Section 701.6 is also authorized by 31 U.S.C. 3717. Section 701.31 
is also authorized by 12 U.S.C. 1601 et seq., 42 U.S.C. 1981 and 42 
U.S.C. 3601-3610. Section 701.35 is also authorized by 12 U.S.C. 
4311-4312.


0
2. Amend Sec.  701.34 as follows:
0
a. Revise the section heading to read as set forth below;
0
b. Revise paragraphs (b) and (c) to read as set forth below;
0
c. Add new paragraph (d) before the Appendix to Sec.  701.34 to read as 
set forth below; and
0
d. Revise the Appendix to Sec.  701.34 following new paragraph (d) to 
read as follows:


Sec.  701.34  Designation of low income status; Acceptance of secondary 
capital accounts by low-income designated credit unions.

* * * * *
    (b) Acceptance of secondary capital accounts by low-income 
designated credit unions. A federal credit union having a designation 
of low-income status pursuant to paragraph (a) of this section may 
accept secondary capital accounts from nonnatural person members and 
nonnatural person nonmembers subject to the following conditions:
    (1) Secondary capital plan. Before accepting secondary capital, a 
low-income credit union (``LICU'') shall adopt, and forward to the 
appropriate NCUA Regional Director for approval, a written ``Secondary 
Capital Plan'' that, at a minimum:
    (i) States the maximum aggregate amount of uninsured secondary 
capital the LICU plans to accept;
    (ii) Identifies the purpose for which the aggregate secondary 
capital will be used, and how it will be repaid;
    (iii) Explains how the LICU will provide for liquidity to repay 
secondary capital upon maturity of the accounts;
    (iv) Demonstrates that the planned uses of secondary capital 
conform to the LICU's strategic plan, business plan and budget; and
    (v) Includes supporting pro forma financial statements, including 
any off-

[[Page 4239]]

balance sheet items, covering a minimum of the next two years.
    (2) Decision on plan. If a LICU is not notified within 45 days of 
receipt of a Secondary Capital Plan that the plan is approved or 
disapproved, the LICU may proceed to accept secondary capital accounts 
pursuant to the plan.
    (3) Nonshare account. The secondary capital account must be 
established as an uninsured secondary capital account or other form of 
non-share account.
    (4) Minimum maturity. The maturity of the secondary capital account 
must be a minimum of five years.
    (5) Uninsured account. The secondary capital account will not be 
insured by the National Credit Union Share Insurance Fund or any 
governmental or private entity.
    (6) Subordination of claim. The secondary capital account 
investor's claim against the LICU must be subordinate to all other 
claims including those of shareholders, creditors and the National 
Credit Union Share Insurance Fund.
    (7) Availability to cover losses. Funds deposited into a secondary 
capital account, including interest accrued and paid into the secondary 
capital account, must be available to cover operating losses realized 
by the LICU that exceed its net available reserves (exclusive of 
secondary capital and allowance accounts for loan and lease losses), 
and to the extent funds are so used, the LICU must not restore or 
replenish the account under any circumstances. The LICU may, in lieu of 
paying interest into the secondary capital account, pay accrued 
interest directly to the investor or into a separate account from which 
the secondary capital investor may make withdrawals. Losses must be 
distributed pro-rata among all secondary capital accounts held by the 
LICU at the time the losses are realized.
    (8) Security. The secondary capital account may not be pledged or 
provided by the account investor as security on a loan or other 
obligation with the LICU or any other party.
    (9) Merger or dissolution. In the event of merger or other 
voluntary dissolution of the LICU, other than merger into another LICU, 
the secondary capital accounts will be closed and paid out to the 
account investor to the extent they are not needed to cover losses at 
the time of merger or dissolution.
    (10) Contract agreement. A secondary capital account contract 
agreement must be executed by an authorized representative of the 
account investor and of the LICU reflecting the terms and conditions 
mandated by this section and any other terms and conditions not 
inconsistent with this section.
    (11) Disclosure and acknowledgement. An authorized representative 
of the LICU and of the secondary capital account investor each must 
execute a ``Disclosure and Acknowledgment'' as set forth in the 
Appendix to this section at the time of entering into the account 
agreement. The LICU must retain an original of the account agreement 
and the ``Disclosure and Acknowledgment'' for the term of the 
agreement, and a copy must be provided to the account investor.
    (12) Prompt corrective action. As provided in Sec. Sec.  
702.204(b)(11), 702.304(b) and 702.305(b) of this chapter, the NCUA 
Board may prohibit a LICU classified ``critically undercapitalized'' 
or, if ``new,'' as ``moderately capitalized'', ``marginally 
capitalized'', ``minimally capitalized'' or ``uncapitalized'', as the 
case may be, from paying principal, dividends or interest on its 
uninsured secondary capital accounts established after August 7, 2000, 
except that unpaid dividends or interest will continue to accrue under 
the terms of the account to the extent permitted by law.
    (c) Accounting treatment; Recognition of net worth value of 
accounts. (1) Equity account. A LICU that issues secondary capital 
accounts pursuant to paragraph (b) of this section must record the 
funds on its balance sheet in an equity account entitled ``uninsured 
secondary capital account.''
    (2) Schedule for recognizing net worth value. For accounts with 
remaining maturities of less than five years, the LICU must reflect the 
net worth value of the accounts in its financial statement in 
accordance with the following schedule:

------------------------------------------------------------------------
                                                              Net worth
                                                               value of
                     Remaining maturity                        original
                                                               balance
                                                              (percent)
------------------------------------------------------------------------
Four to less than five years...............................           80
Three to less than four years..............................           60
Two to less than three years...............................           40
One to less than two years.................................           20
Less than one year.........................................            0
------------------------------------------------------------------------

    (3) Financial statement. The LICU must reflect the full amount of 
the secondary capital on deposit in a footnote to its financial 
statement.
    (d) Redemption of secondary capital. With the written approval of 
the appropriate Regional Director, secondary capital that is not 
recognized as net worth under paragraph (c)(2) of this section 
(``discounted secondary capital'' recategorized as subordinated debt) 
may be redeemed according to the remaining maturity schedule in 
paragraph (d)(3) of this section.
    (1) Request to redeem secondary capital. A request for approval to 
redeem discounted secondary capital may be submitted in writing at any 
time, must specify the increment(s) to be redeemed and the schedule for 
redeeming all any part of each eligible increment, and must demonstrate 
to the satisfaction of the appropriate Regional Director that:
    (i) The LICU will have a post-redemption net worth classification 
of ``adequately capitalized'' under part 702 of this chapter;
    (ii) The discounted secondary capital has been on deposit at least 
two years;
    (iii) The discounted secondary capital will not be needed to cover 
losses prior to final maturity of the account;
    (iv) The LICU's books and records are current and reconciled;
    (v) The proposed redemption will not jeopardize other current 
sources of funding, if any, to the LICU; and
    (vi) The request to redeem is authorized by resolution of the 
LICU's board of directors.
    (2) Decision on request. A request to redeem discounted secondary 
capital may be granted in whole or in part. If a LICU is not notified 
within 45 days of receipt of a request for approval to redeem secondary 
capital that its request is either granted or denied, the LICU may 
proceed to redeem secondary capital accounts as proposed.
    (3) Schedule for redeeming secondary capital.

------------------------------------------------------------------------
                                                              Redemption
                                                               limit as
                     Remaining maturity                       percent of
                                                               original
                                                               balance
------------------------------------------------------------------------
Four to less than five years...............................           20
Three to less than four years..............................           40
Two to less than three years...............................           60
One to less than two years.................................           80
------------------------------------------------------------------------

Appendix to Sec.  701.34

    A LICU that is authorized to accept uninsured secondary capital 
accounts and each investor in such an account shall execute and date 
the following ``Disclosure and Acknowledgment'' form, a signed 
original of which must be retained by the credit union:

Disclosure and Acknowledgment

    [Name of CU] and [Name of investor] hereby acknowledge and agree 
that [Name of investor] has committed [amount of funds] to a 
secondary capital account with [name of credit union] under the 
following terms and conditions:
    1. Term. The funds committed to the secondary capital account 
are committed for a period of ---- years.
    2. Redemption prior to maturity. Subject to the conditions set 
forth in 12 CFR 701.34, the funds committed to the secondary capital 
account are redeemable prior to maturity

[[Page 4240]]

only at the option of the LICU and only with the prior approval of 
the appropriate regional director.
    3. Uninsured, non-share account. The secondary capital account 
is not a share account and the funds committed to the secondary 
capital account are not insured by the National Credit Union Share 
Insurance Fund or any other governmental or private entity.
    4. Prepayment risk. Redemption of U.S.C. prior to the account's 
original maturity date may expose the account investor to the risk 
of being unable to reinvest the repaid funds at the same rate of 
interest for the balance of the period remaining until the original 
maturity date. The investor acknowledges that it understands and 
assumes responsibility for prepayment risk associated with the [name 
of credit union]'s redemption of the investor's U.S.C. account prior 
to the original maturity date.
    5. Availability to cover losses. The funds committed to the 
secondary capital account and any interest paid into the account may 
be used by [name of credit union] to cover any and all operating 
losses that exceed the credit union's net worth exclusive of 
allowance accounts for loan losses, and in the event the funds are 
so used, (name of credit union) will under no circumstances restore 
or replenish those funds to [name of institutional investor]. 
Dividends are not considered operating losses and are not eligible 
to be paid out of secondary capital.
    6. Accrued interest. By initialing below, [name of credit union] 
and [name of institutional investor] agree that accrued interest 
will be:

----Paid into and become part of the secondary capital account;
----Paid directly to the investor;
----Paid into a separate account from which the investor may make 
withdrawals; or
----Any combination of the above provided the details are specified 
and agreed to in writing.

    7. Subordination of claims. In the event of liquidation of [name 
of credit union], the funds committed to the secondary capital 
account will be subordinate to all other claims on the assets of the 
credit union, including claims of member shareholders, creditors and 
the National Credit Union Share Insurance Fund.
    8. Prompt Corrective Action. Under certain net worth 
classifications (see 12 CFR 702.204(b)(11), 702.304(b) and 
702.305(b), as the case may be), the NCUA Board may prohibit [name 
of credit union] from paying principal, dividends or interest on its 
uninsured secondary capital accounts established after August 7, 
2000, except that unpaid dividends or interest will continue to 
accrue under the terms of the account to the extent permitted by 
law.

ACKNOWLEDGED AND AGREED TO this ---- day of [month and year] by:
-----------------------------------------------------------------------
[name of investor's official]
[title of official]
[name of investor]
[address and phone number of investor]
[investor's tax identification number]

-----------------------------------------------------------------------
[name of credit union official]
[title of official]

PART 741--REQUIREMENTS FOR INSURANCE

0
1. The authority citation for part 741 continues to read as follows:

    Authority: 12 U.S.C. 1757, 1766, 1781--1790, and 1790d. Section 
741.4 is also authorized by 31 U.S.C. 3717.


0
2. Amend Sec.  741.204 as follows:
0
a. Remove from paragraph (c) the citation ``Sec.  701.34'' wherever it 
appears and add in its place the citation ``Sec.  701.34(b)(1)'';
0
b. Revise the second sentence of paragraph (c) and add a new third 
sentence to read as set forth below; and
0
c. Add new paragraph (d) to read as set forth below:


Sec.  741.204  Maximum public unit and nonmember accounts, and low 
income designation.

* * * * *
    (c) * * * State chartered federally insured credit unions offering 
secondary capital accounts must submit the plan required by Sec.  
701.34(B)(1) to both the state supervisory authority and the NCUA 
Regional Director for approval. The state supervisory authority must 
approve or disapprove the plan with the concurrence of the appropriate 
NCUA Regional Director.
    (d) Redeem secondary capital accounts only in accordance with the 
terms and conditions authorized for federal credit unions pursuant to 
Sec.  701.34(d) of this chapter and to the extent not inconsistent with 
applicable state law and regulation. State chartered federally insured 
credit unions seeking to redeem secondary capital accounts must submit 
the request required by Sec.  701.34(d)(1) to both the state 
supervisory authority and the NCUA Regional Director. The state 
supervisory authority must grant or deny the request with the 
concurrence of the appropriate NCUA Regional Director.

[FR Doc. 06-686 Filed 1-25-06; 8:45 am]
BILLING CODE 7535-01-P