Prompt Corrective Action; Amended Definition of Post-Merger Net Worth, 44197-44201 [E8-17415]

Agencies

• National Credit Union Administration

[Federal Register Volume 73, Number 147 (Wednesday, July 30, 2008)]
[Proposed Rules]
[Pages 44197-44201]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-17415]


=======================================================================
-----------------------------------------------------------------------

NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 702 and 704

RIN 3133-AD43


Prompt Corrective Action; Amended Definition of Post-Merger Net 
Worth

AGENCY: National Credit Union Administration (NCUA).

ACTION: Proposed rule.

-----------------------------------------------------------------------

SUMMARY: NCUA requests public comment on a proposed rule implementing a 
statutory amendment to the definition of a natural person credit 
union's ``net worth'' that applies solely to NCUA's system of 
regulatory capital standards, known as ``prompt corrective action.'' 
The amendment expands the definition of ``net worth'' to allow the 
acquiring credit union, in a merger of natural person credit unions, to 
include the merging credit union's retained earnings with its own to 
determine the acquirer's post-merger ``net worth.'' In a merger of 
corporate credit unions, the proposed rule similarly redefines 
corporate credit union capital to allow an acquiring credit union to 
include with its capital the retained earnings of the merging credit 
union to determine the acquirer's post-merger capital.

DATES: Comments must be received on or before September 29, 2008.

ADDRESSES: You may submit comments by any of the following methods 
(Please send comments by one method only):
     Federal eRulemaking Portal: https://www.regulations.gov. 
Follow the instructions for submitting comments.
     NCUA Web Site: https://www.ncua.gov/
RegulationsOpinionsLaws/proposed_regs/proposed_regs.html. Follow the 
instructions for submitting comments.
     E-mail: Address to regcomments@ncua.gov. Include ``[Your 
name]--
    Comments on Notice of Proposed Rulemaking for Parts 702 and 704'' 
in the e-mail subject line.
     Fax: (703) 518-6319. Use the subject line described above 
for e-mail.
     Mail: Address to Mary Rupp, Secretary of the Board, 
National Credit Union Administration, 1775 Duke Street, Alexandria, 
Virginia 22314-3428.
     Hand Delivery/Courier: Same as mail address.

FOR FURTHER INFORMATION CONTACT: Technical: Karen Kelbly, Chief 
Accountant, Office of Examination and Insurance, at the above address 
or by telephone: 703/518-6389; Legal: Steven W. Widerman, Trial 
Attorney, Office of General Counsel, at the above address or by 
telephone: 703/518-6557.

SUPPLEMENTARY INFORMATION:

A. Background

1. Natural Person Credit Unions

    a. Prompt Corrective Action. In 1998, Congress enacted the Credit 
Union Membership Access Act (``CUMAA''), Public Law 105-219, 112 Stat. 
913 (1998). CUMAA amended the Federal Credit Union Act to mandate a 
system of regulatory capital standards called ``prompt corrective 
action'' (``PCA'' or ``regulatory capital'') consisting of

[[Page 44198]]

minimum capital standards and corresponding remedies to improve the net 
worth of federally-insured ``natural person'' credit unions. 12 U.S.C. 
1790d et seq. In 2000, the NCUA Board implemented a comprehensive 
system of PCA primarily under part 702.\1\ 12 CFR 702 et seq.
---------------------------------------------------------------------------

    \1\ Since it was first adopted, part 702 has been amended four 
times. The first amendment incorporated limited technical 
corrections. 65 FR 55439 (Sept. 14, 2000). The second amendment 
deleted sections made obsolete by adoption of a uniform quarterly 
schedule for filing Call Reports. 67 FR 12459 (March 19, 2002). The 
third amendment incorporated a series of revisions and adjustments 
to improve and simplify the implementation of PCA. 67 FR 71078 (Nov. 
29, 2002). Finally, the fourth amendment added a third risk-
weighting tier to the standard risk-based net worth component for 
member business loans. 68 FR 56537, 56546 (Oct. 1, 2003). A proposal 
to modify the criteria for filing a net worth restoration plan, 67 
FR 7113 (Nov. 29, 2002), was never adopted.
---------------------------------------------------------------------------

    A credit union's ``net worth ratio'' determines its classification 
among five statutory net worth categories. 12 U.S.C. 1790d(c); 12 CFR 
702.102. As a credit union's classification among these categories 
declines, it is subject to an expanding range of PCA remedies to 
restore its net worth. These remedies consist of four mandatory 
supervisory actions prescribed by statute, 12 U.S.C. 1790d(e)-(g), and 
a series of discretionary supervisory actions developed by NCUA. 12 CFR 
702.204(b).
    CUMMA defines a natural person credit union's ``net worth ratio'' 
as the ratio of its net worth to its total assets. 12 U.S.C. 
1790d(o)(3). For regulatory capital purposes,\2\ it expressly limits a 
credit union's net worth to ``the retained earnings balance of the 
credit union, as determined under generally accepted accounting 
principles [``GAAP''].'' 12 U.S.C. 1790d(o)(2)(A) (1998).\3\ ``Not 
anticipating the consequences this rule addresses, the CUMAA net worth 
definition thus incorporated GAAP by reference generally, subject to 
future amendments and interpretations; it did not incorporate GAAP as a 
snapshot that preserved what GAAP then prescribed or how it was then 
interpreted.
---------------------------------------------------------------------------

    \2\ In contrast, for financial reporting purposes, CUMMA 
requires credit unions to adhere to GAAP in the Call Reports 
required to be filed with the NCUA Board. 12 U.S.C. 
1782(a)(6)(C)(i).
    \3\ In contrast to NCUA, Congress gave the other federal 
financial institution regulators the latitude to prescribe the 
``relevant capital measures'' of their institutions. 12 U.S.C. 
1831o(c)(1). As a result, the ``core capital'' of banks and thrifts 
is defined to include virtually all GAAP equity components, 12 CFR 
325.2(v), whereas credit union capital is limited by law to the 
``retained earnings'' component of equity. 12 CFR 702.2(f).
---------------------------------------------------------------------------

    b. Financial Reporting of Mergers Between Mutual Enterprises. GAAP 
pertaining to credit union mergers were originally embodied in the 
financial reporting rules for business combinations established by the 
Accounting Principles Board's (``APB'') Opinion No. 16, Business 
Combinations (1970) (``Opinion 16''). At the time CUMAA mandated PCA, 
the predominant practice for financial reporting of a credit union 
merger, whether of natural person or corporate credit unions, was to 
apply the ``pooling method.'' That method required an acquiring or 
continuing credit union (``acquiring credit union'') to combine with 
its own financial statement components the like components of the 
merging credit union. Consistent with the limited statutory definition 
of net worth, that method allowed an acquiring credit union to combine 
its own retained earnings with that of the merging credit union for 
purposes of measuring the acquirer's post-merger net worth ratio. The 
``pooling method'' presumed that the retained earnings of the merging 
credit union flowed forward to the acquirer's financial statement, thus 
qualifying it as retained earnings of the acquirer.
    The ``pooling method,'' in conjunction with the statutory 
definition of net worth, provided an incentive to merge because it 
allowed the acquiring credit union to combine the merging credit 
union's retained earnings, thus enhancing the acquirer's post-merger 
net worth. From a regulatory standpoint, the acquisition of an 
operationally troubled credit union by one that will be well 
capitalized as a result is a preferable alternative to conserving or 
liquidating the troubled credit union.
    In 2001, the Financial Accounting Standards Board (``FASB'')--
successor to the APB--replaced Opinion 16 as the source of GAAP for 
business combinations other than those between mutual enterprises with 
its Financial Accounting Statement No. 141, Business Combinations 
(2002) (``FAS 141''). FAS 141 replaced the ``pooling method'' of 
financial reporting of business combinations with the ``purchase 
method'' effective in June 30, 2001.
    c. Deferment of ``Acquisition Method'' for Mutual Combinations. For 
mergers between mutual enterprises (``mutual combinations'') such as 
credit unions, FASB deferred the 2001 effective date of FAS 141 pending 
the outcome of its project on Combinations Between Mutual Enterprises, 
which explored a ``differences-based approach'' to mutual combinations. 
FAS 141 at ] 60. While the FAS 141 deferment for mutual combinations is 
pending, Opinion 16 continues to apply, and credit unions continue to 
use the ``pooling method'' of financial reporting of credit union 
mergers. But that deferment will expire at the end of 2008.
    In December 2007, FASB decided that its revised method of financial 
reporting for business combinations should apply equally to mutual 
combinations and to combinations between other for-profit enterprises. 
Financial Accounting Statement No. 141(R), Business Combinations (2007) 
(``FAS 141(R)'') at ] 74. FAS 141(R) will apply to mutual combinations 
that take place in fiscal years beginning after December 15, 2008. In 
conjunction with the limited statutory definition of net worth, the net 
effect of FAS 141(R) is to mandate the ``purchase method'' of financial 
reporting--which it renamed the ``acquisition method''--for credit 
union mergers, resulting in the exclusion of a merging credit union's 
retained earnings from the post-merger net worth of an acquiring credit 
union.
    d. Acquisition Versus Pooling Method of Financial Reporting. The 
``acquisition method'' of financial reporting for credit unions would 
require the fair value of the net assets acquired in a merger to be 
classified as a direct addition to the acquirer's equity, not as an 
addition to its retained earnings. FAS 141(R) at ] A67. Because credit 
unions cannot count additions of equity in their net worth--which is 
limited by definition to GAAP retained earnings--an acquirer's net 
worth will not increase as the result of a merger. Moreover, the 
``acquisition method'' may well reduce an acquirer's post-merger net 
worth because, as a ratio of total assets, it will be diluted by the 
addition and fair valuation of assets (i.e., the denominator of the 
ratio) acquired in the merger.
    Whereas the ``pooling method'' of financial reporting, when applied 
in conjunction with the statutory definition of net worth, provided an 
incentive to merge, the ``acquisition method'' would have exactly the 
opposite effect. The acquiring credit union's net worth ratio not only 
would not increase as a result of a merger, it probably would decline. 
The risk of being demoted to a lower PCA net worth category, and in 
turn being exposed to the mandatory and discretionary supervisory 
actions of PCA, would naturally discourage interest in mergers, thus 
limiting their availability to rescue troubled credit unions.
    e. Statutory Expansion of Net Worth Definition. Concerned that FAS 
141(R), in conjunction with the statutory limitation on net worth, 
would stifle credit union mergers, Congress enacted the Financial 
Services Regulatory Relief Act, Public Law 109-351, 120 Stat. 1966 
(``2006 Relief Act'') in 2006. Section 504 of the 2006 Relief Act 
expanded the

[[Page 44199]]

original PCA definition of a natural person credit union's ``net 
worth'' to include ``any amounts that were previously retained earnings 
of any other credit union with which [it] has combined.'' 12 U.S.C. 
1790d(o)(2)(A) (2006). The express purpose of section 504 is to allow 
the acquiring credit union ``to follow the new FASB rule while still 
allowing the capital of both credit unions to flow forward as 
regulatory capital and thus preserve the incentive for desirable credit 
union mergers.'' Staff of Senate Comm. on Banking, Housing and Urban 
Affairs, 109th Cong., Section-By-Section Analysis of Financial Services 
Regulatory Relief Act of 2006 (Comm. Print 2006) at 3.\4\ To conform to 
the effective date of FAS 141(R), the modifications to part 702 
implementing section 504 must take effect in final form on December 31, 
2008, so that they will apply to natural person credit union mergers 
taking place after that date.
---------------------------------------------------------------------------

    \4\ Available at: https://banking.senate.gov/public/_files/
RegRel_summary.pdf.
---------------------------------------------------------------------------

    The following table compares the financial reporting and regulatory 
capital consequences of a credit union merger under present GAAP (pre-
FAS 141(R)) and under new GAAP (post-FAS 141(R)) both with and without 
the proposed modifications to part 702:
[GRAPHIC] [TIFF OMITTED] TP30JY08.037

2. Corporate Credit Unions

    Corporate credit unions are exempt from PCA, 12 U.S.C. 1790d(m), 
but they are subject to a minimum ``capital ratio'' and to a 
requirement to calculate their ``retained earnings ratio'' on a monthly 
basis, both as provided by regulation.
    a. Minimum Capital Ratio. A corporate credit union's ``capital 
ratio'' is defined as its capital (numerator) divided by its ``moving 
daily average net assets'' (denominator). 12 CFR 704.2. Its ``capital'' 
consists of the sum of its retained earnings, paid-in capital, and 
membership capital. Id. Of these, retained earnings and paid-in capital 
constitute ``core capital.'' Id. A corporate credit union is required 
to maintain a minimum capital ratio of four percent (4%) calculated at 
least monthly. 12 CFR 704.3(d). When its capital ratio falls and 
remains below that minimum, the corporate credit union is subject to 
remedies that resemble some of the mandatory and discretionary 
supervisory actions of PCA (e.g., ``capital restoration plan,'' 
earnings retention requirement, and ``capital directives''). 12 CFR 
704.2(g), (h) and (i).
    b. Retained Earnings Ratio. A corporate credit union's ``retained 
earnings ratio'' is defined as its retained earnings divided by its 
moving daily average net assets. 12 CFR 704.2. A corporate credit union 
is required to

[[Page 44200]]

calculate its ``retained earnings ratio'' on a monthly basis. 12 CFR 
704.3(i). If the retained earnings ratio is less than 2 percent, the 
credit union becomes subject to an earnings retention requirement. Id.

3. Issues for Comment

    NCUA welcomes public comment on this proposed rule. To facilitate 
consideration of the public's views, we ask commenters to organize and 
identify their comments by credit union type (natural person or 
corporate) or regulation (part 702 or part 704) and by corresponding 
topic or definition. General comments, if any, should be included in a 
separately identified section. Please recognize that NCUA does not 
establish GAAP, does not oversee FASB, does not have the power to 
reinstate the ``pooling method,'' and does not have the authority to 
override or expand limitations and definitions prescribed by law. 
Therefore, this rulemaking will not address comments advocating any of 
these actions.

B. Discussion of Proposed Modifications

1. Part 702--Natural Person Credit Union's Post-Merger Net Worth

    The 2006 Relief Act's redefinition of ``net worth'' for natural 
person credit unions is implemented through Part 702's PCA definitions. 
The present definition of ``net worth,'' 12 CFR 702.2(f), is 
reorganized into subsections and includes the following new subsection:

    (3) For a credit union that acquires another credit union in a 
mutual combination, net worth also includes the retained earnings of 
the acquired credit union, or of an integrated set of activities and 
assets, at the point of acquisition. A mutual combination is a 
transaction in which a credit union acquires either another credit 
union, or an integrated set of activities and assets that is capable 
of being conducted and managed as a credit union for the purpose of 
providing a return in the form of economic benefits directly to 
owner members.

In the first sentence, proposed subsection (3) adds to an acquiring 
credit union's net worth an amount equal to the merging credit union's 
retained earnings balance at the point it was acquired, yielding a 
regulatory capital measure that approximates the net worth previously 
obtainable under the ``pooling method.'' \5\
---------------------------------------------------------------------------

    \5\ The result approximates, but does not duplicate, that of the 
``pooling method'' because CUMAA does not authorize a corresponding 
exclusion of intangibles from the ``total assets'' denominator of 
the net worth ratio.
---------------------------------------------------------------------------

    Proposed subsection (3) is not limited in scope to the acquisition 
by merger of a credit union as an intact legal entity. FAS 141(R) at 
]3d. The definition of ``mutual combination'' in the second sentence 
incorporates the GAAP definition of a ``business'' and a ``business 
combination.'' FAS 141(R) at ]]3d-e. This allows subsection (3) to 
apply to transactions (e.g., certain purchase and assumptions) that 
convey substantially all of the components of a credit union, even 
though the components together no longer legally constitute a credit 
union.
    The net effect of the modifications to part 702 is to apply FAS 
141(R) to natural person credit union mergers for financial reporting 
purposes, while for PCA purposes replicating the post-merger net worth 
that would have resulted under the ``pooling method.'' These 
modifications affect only the measurement of a credit union's post-
merger regulatory capital under PCA; financial reporting in its Call 
Report still must adhere to GAAP (i.e., acquirer's retained earnings 
balance must be reported consistent with GAAP). 12 U.S.C. 
1782(a)(6)(C)(i).

2. Part 704--Corporate Credit Union's Post-Merger Capital

    The proposed rule modifies part 704 [Corporate Credit Unions] to 
expand the definitions associated with corporate credit union capital 
to correspond with the statutory expansion of net worth for natural 
person credit unions. As such, the definition of the ``capital'' and 
``core capital'' of a corporate credit union that acquires another 
credit union by merger is modified to include ``the retained earnings 
of the acquired credit union, or of an integrated set of activities and 
assets, at the point of acquisition.'' The same modification is made to 
the definition of a corporate credit union's ``retained earnings 
ratio.'' Further, to encompass not only the acquisition of a credit 
union as an intact legal entity, but also as a group of credit union 
components that together are no longer legally constituted as such, the 
proposed rule adds a separate definition of ``mutual combination'' 
that, like proposed section 702.2(f)(3), incorporates the GAAP 
definition of ``business'' and ``business combination.''
    The NCUA Board has greater flexibility to define corporate credit 
union capital than the 2006 Relief Act allows for the net worth of 
natural person credit unions. 12 U.S.C. 1766(a). Therefore, to more 
closely approximate the regulatory capital result of the ``pooling 
method,'' identifiable and unidentifiable intangibles are excluded from 
the definition of a corporate credit union's ``moving daily average net 
assets'' (``MDANA'')--the denominator of the capital ratio. 
Identifiable intangibles could include existing member relationships 
(i.e., core deposit intangibles) and unserved portions of a field of 
membership; unidentifiable intangibles include predominantly goodwill. 
The purpose of excluding intangibles from the MDANA denominator of the 
capital ratio is to approximate the denominator of the capital ratio 
under the ``pooling method.'' That denominator did not reflect the 
merging credit union's intangibles, nor the increased valuation of its 
tangible assets. This approach resembles the approach followed by other 
Federal banking regulators.
    Even though the statutory definition of net worth does not permit 
natural person credit unions to exclude intangibles, allowing corporate 
credit unions to do so approximates for regulatory capital purposes the 
result that would have been achieved under the ``pooling method.'' The 
Board welcomes public comment on whether this approach adequately 
addresses the risk of devaluation and possible loss to the National 
Credit Union Share Insurance Fund.
    The net effect of the modifications to part 704 is to apply FAS 
141(R) to financial reporting of corporate credit union mergers while 
replicating the post-merger capital, capital ratio and retained 
earnings that would have resulted under the ``pooling method.'' These 
modifications to part 704 must take effect in final form on December 
31, 2008, to parallel the effective date of the modifications to part 
702 that implement the expanded definition of ``net worth.''

Regulatory Procedures

Regulatory Flexibility Act

    The Regulatory Flexibility Act requires NCUA to prepare an analysis 
describing any significant economic impact a proposed regulation may 
have on a substantial number of small credit unions (primarily those 
under $10 million in assets). The proposed rule implements an Act of 
Congress expanding the definition of a natural person credit union's 
net worth. 12 U.S.C. 1790d(o)(2)(A) (2006). The rule affects the 
calculation of the post-merger net worth of an acquiring credit union, 
the vast majority of which exceed $10 million in assets. Accordingly, 
the proposed rule, if adopted, will not have a significant economic 
impact on a substantial number of small credit unions. The NCUA Board 
invites comment on this issue.

[[Page 44201]]

Paperwork Reduction Act

    NCUA has determined that the proposed rule would not increase 
paperwork requirements under the Paperwork Reduction Act of 1995 and 
regulations of the Office of Management and Budget. Control number 
3133-0154 has been issued for part 702 and control number 3133-0129 has 
been issued for part 704. Both will be displayed in the table at 12 CFR 
part 795.

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 proposed rule would 
apply to all federally-insured credit unions, including State-chartered 
credit unions, and thus may raise some federalism implications. 
However, the proposal is unlikely to have a 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 because it facilitates, rather than 
diminishes, the ability of state-chartered credit unions to combine 
with other credit unions.

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, Public Law 105-277, 112 Stat. 2681 
(1998).

List of Subjects in 12 CFR Parts 702 and 704

    Credit unions, Reporting and recordkeeping requirements, Surety 
bonds.

    By the National Credit Union Administration Board on July 24, 
2008.
Mary Rupp,
Secretary of the Board.
    For the reasons set forth above, NCUA proposes to amend 12 CFR 
parts 702 and 704 as follows:

PART 702--PROMPT CORRECTIVE ACTION

    1. The authority citation for part 702 continues to read as 
follows:

    Authority: 12 U.S.C. 1766(a), 1790d.

    2. Amend Sec.  702.2 by revising paragraph (f) to read as follows:


Sec.  702.2  Definitions.

* * * * *
    (f) Net Worth means--
    (1) The retained earnings balance of the credit union at quarter-
end as determined under generally accepted accounting principles, 
subject to paragraph (f)(3) of this section. Retained earnings consists 
of undivided earnings, regular reserves, and any other appropriations 
designated by management or regulatory authorities;
    (2) For a low income-designated credit union, net worth also 
includes secondary capital accounts that are uninsured and subordinate 
to all other claims, including claims of creditors, shareholders and 
the NCUSIF; and
    (3) For a credit union that acquires another credit union in a 
mutual combination, net worth includes the retained earnings of the 
acquired credit union, or of an integrated set of activities and 
assets, at the point of acquisition. A mutual combination is a 
transaction in which a credit union acquires another credit union, or 
acquires an integrated set of activities and assets that is capable of 
being conducted and managed as a credit union for the purpose of 
providing a return in the form of economic benefits directly to owner 
members.
* * * * *

PART 704--CORPORATE CREDIT UNIONS

    1. The authority citation for part 704 continues to read as 
follows:

    Authority: 12 U.S.C. 1766(a), 1781, 1789.

    2. Amend Sec.  704.2 by:
    a. Revising the current definitions of Capital, Core capital, 
Moving daily average net assets and Retained earnings ratio to read as 
set forth below; and
    b. Adding the definition of Mutual combination following the 
revised definition of Moving daily average net assets, to read as 
follows:


Sec.  704.2  Definitions.

* * * * *
    Capital means the sum of a corporate credit union's retained 
earnings, paid-in capital, and membership capital. For a corporate 
credit union that acquires another credit union in a mutual 
combination, capital includes the retained earnings of the acquired 
credit union, or of an integrated set of activities and assets, at the 
point of acquisition.
* * * * *
    Core capital means the sum of a corporate credit union's retained 
earnings, and paid-in capital. For a corporate credit union that 
acquires another credit union in a mutual combination, core capital 
includes the retained earnings of the acquired credit union, or of an 
integrated set of activities and assets, at the point of acquisition.
* * * * *
    Moving daily average net assets means the average of daily average 
net assets exclusive of identifiable and unidentifiable intangibles for 
the month being measured and the previous eleven (11) months.
    Mutual combination means a transaction or event in which a 
corporate credit union acquires another credit union, or acquires an 
integrated set of activities and assets that is capable of being 
conducted and managed as a credit union for the purpose of providing a 
return in the form of economic benefits directly to owner members.
* * * * *
    Retained earnings ratio means the corporate credit union's retained 
earnings divided by its moving daily average net assets. For a 
corporate credit union that acquires another credit union in a mutual 
combination, the numerator of the retained earnings ratio also includes 
the retained earnings of the acquired credit union, or of an integrated 
set of activities and assets, at the point of acquisition.
* * * * *
 [FR Doc. E8-17415 Filed 7-29-08; 8:45 am]
BILLING CODE 7535-01-P