Alternative Capital, 9691-9702 [2017-01713]

Download as PDF 9691 Proposed Rules Federal Register Vol. 82, No. 25 Wednesday, February 8, 2017 This section of the FEDERAL REGISTER contains notices to the public of the proposed issuance of rules and regulations. The purpose of these notices is to give interested persons an opportunity to participate in the rule making prior to the adoption of the final rules. NATIONAL CREDIT UNION ADMINISTRATION 12 CFR Parts 701, 702, 703, 709, 741, and 745 Alternative Capital National Credit Union Administration. ACTION: Advance notice of proposed rulemaking. AGENCY: The NCUA Board (Board) is issuing this advanced notice of proposed rulemaking (ANPR) to solicit comments on alternative forms of capital federally insured credit unions could use in meeting capital standards required by statute and regulation. For purposes of this ANPR, alternative capital includes two different categories: Secondary capital and supplemental capital. Secondary capital is currently permissible under the Federal Credit Union Act (Act) only for low-income designated credit unions to issue and to be counted toward both the net worth ratio and the risk-based net worth requirement of NCUA’s prompt corrective action standards. The Board is considering changes to the secondary capital regulation for low-income designated credit unions. There are no other forms of alternative capital currently authorized. However, the Board is also considering whether or not to authorize credit unions to issue supplemental capital instruments that would only count towards the riskbased net worth requirement. DATES: Comments must be received on or before May 9, 2017. ADDRESSES: You may submit comments by any one of the following methods (Please send comments by one method only): • Federal eRulemaking Portal: http:// www.regulations.gov. Follow the instructions for submitting comments. • Email: Address to regcomments@ ncua.gov. Include ‘‘[Your name]— Comments on Advance Notice of Proposed Rulemaking for Supplemental Capital’’ in the email subject line. jstallworth on DSK7TPTVN1PROD with PROPOSALS SUMMARY: VerDate Sep<11>2014 15:10 Feb 07, 2017 Jkt 241001 • Fax: (703) 518–6319. Use the subject line described above for email. • Mail: Address to Gerald Poliquin, Secretary of the Board, National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314– 3428. • Hand Delivery/Courier: Same as mail address. Public Inspection: You can view all public comments on NCUA’s Web site at http://www.ncua.gov/Legal/Regs/ Pages/PropRegs.aspx as submitted, except for those we cannot post for technical reasons. NCUA will not edit or remove any identifying or contact information from the public comments submitted. You may inspect paper copies of comments in NCUA’s law library at 1775 Duke Street, Alexandria, Virginia 22314, by appointment weekdays between 9 a.m. and 3 p.m. To make an appointment, call (703) 518– 6546 or send an email to OGCMail@ ncua.gov. FOR FURTHER INFORMATION CONTACT: Steve Farrar, Supervisory Financial Analyst, at (703) 518–6360; or Justin Anderson, Senior Staff Attorney, Office of General Counsel, at (703) 518–6540. You may also contact them at the National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314. SUPPLEMENTARY INFORMATION: At its October 2016 meeting, the Board held a public briefing on the topic of alternative capital for credit unions. This ANPR provides relevant background information and seeks comment on a broad range of considerations with respect to alternative capital for federally insured credit unions. This ANPR addresses topics including: (1) NCUA’s authority to include alternative capital for prompt corrective action purposes; (2) credit unions’ authority to issue alternative forms of capital; (3) prudential standards regarding the extent to which various forms of instruments would qualify as capital for prompt corrective action purposes and credit union eligibility for the sale of alternative capital; (4) the utility and suitability of supplemental capital for credit unions; (5) standards for investor protection, including disclosure requirements and investor eligibility criteria for the purchase of alternative capital; (6) implications of securities law for supplemental and secondary capital; (7) PO 00000 Frm 00001 Fmt 4702 Sfmt 4702 potential implications for credit unions, including the credit union tax exemption; and (8) overall regulatory changes the Board would need to make to permit supplemental capital, improve secondary capital standards, and provide or modify related supporting authorities. The Board has posed a number of specific questions on these and other topics, but invites comments on any and all aspects of alternative capital. I. Background II. Current Secondary Capital Standards III. Current and Prospective Use of Alternative Capital IV. Supplemental Capital Legal Authority and Potential Taxation Implications V. Securities Law Applicability VI. Other Investor Considerations VII. Prudential Standards for Issuing and Counting Alternative Capital for Prompt Corrective Action VIII. Supporting Regulatory Changes I. Background In 1998, Congress passed the Credit Union Membership Access Act (CUMAA) which amended the Act to mandate a system of prompt corrective action for federally insured natural person credit unions (credit unions).1 The prompt corrective action system incorporates capital standards for credit unions. The Act indexes a credit union’s prompt corrective action status to five categories: Well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized.2 As a credit union’s capital level falls, its classification among the prompt corrective action categories can decline below well capitalized, thus exposing it to an expanding range of mandatory and discretionary supervisory actions designed to remedy the problem and minimize any loss to the National Credit Union Share Insurance Fund (Share Insurance Fund).3 The Act defines a credit union’s capital level based on a net worth ratio requirement for all credit unions and a risk-based net worth requirement for credit unions the Board defines as 1 The Credit Union Membership Access Act of 1998, HR 1151, Public Law 105–219, 112 Stat. 913 (1998). 2 12 U.S.C. 1790d(c); 12 CFR part 702; 65 FR 8560 (Feb. 18, 2000); see 702 subpart C for categories for ‘‘new’’ credit unions. 3 Id. at § 1790d(e), (f) and (g); 12 CFR 702 subpart B. E:\FR\FM\08FEP1.SGM 08FEP1 9692 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules jstallworth on DSK7TPTVN1PROD with PROPOSALS complex.4 The Act also provides the NCUA Board with broad discretion to design the risk-based net worth requirement. However, the net worth ratio is defined in the Act as a credit union’s ratio of net worth to total assets. The Act defines net worth as: 5 • The retained earnings balance of the credit union, as determined under generally accepted accounting principles, together with any amounts that were previously retained earnings of any other credit union with which the credit union is combined; • Secondary capital of a low-income designated credit union that is uninsured and subordinate to all other claims of the credit union, including the claims of creditors, shareholders, and the Share Insurance Fund; and 6 • Certain assistance provided under section 208 of the Act pursuant to NCUA regulations.7 As noted above, per the Act, secondary capital is currently only permissible for low-income designated credit unions to issue and to be counted toward the net worth ratio. NCUA also counts secondary capital issued by lowincome designated credit unions as net worth for the risk-based net worth ratio. The Board notes that, NCUA cannot change the Act’s definition of net worth—only Congress can. However, the Board has broad discretion in designing the risk-based net worth requirement. Thus, it is possible for the Board to authorize a credit union that is not low-income designated to issue alternative capital instruments that would count towards satisfying the riskbased net worth requirement—but not the net worth ratio. (See the discussion of legal authority in Section IV). For purposes of this ANPR, the term supplemental capital includes any form of capital instruments credit unions that 4 In 2000, NCUA adopted part 702 of NCUA Rules and Regulations to implement the Act’s system of prompt corrective action. 5 Id. at § 1790d(o)(3); 12 CFR 702.2(g) and (k). 6 In 1996, the NCUA Board authorized lowincome designated credit unions, including state chartered credit unions to the extent permitted by state law, to count as capital uninsured secondary capital. At the time, the Board recognized that it was difficult for low-income designated credit unions to accumulate capital only through retained earnings. The Board, therefore, permitted lowincome designated credit unions to use the borrowing authority in the Act to issue secondary capital accounts. This authority would allow these credit unions to build capital to support greater lending and financial services to their members and their communities, and to absorb losses to protect them from failing. To ensure the safety and soundness of secondary capital activity, the 1996 rule imposed various restrictions on its use and structure. At this time, prompt corrective action and the associated definition of net worth was not yet part of the Act. 61 FR 50696 (Sept. 27, 1996). 7 12 U.S.C. 1790d(o)(2). VerDate Sep<11>2014 15:10 Feb 07, 2017 Jkt 241001 are not designated as low-income might be authorized to issue and count only for inclusion in the risk-based net worth requirement. The risk-based net worth requirement for federally insured credit unions is based on a risk-based net worth ratio calculation in Part 702 of NCUA’s Rules and Regulations.8 Per the Board’s October 2015 final rule, on January 1, 2019, the risk-based net worth requirement will be updated to replace the risk-based net worth ratio with a new risk-based capital ratio.9 During the risk-based capital rulemaking process, the Board asked for stakeholder input on supplemental capital. Specifically, in the January 2015 risk-based capital (RBC) proposal the NCUA Board posed the following six questions: 10 1. Should additional supplemental forms of capital be included in the RBC numerator and how would including such capital protect the Share Insurance Fund from losses? 2. If yes, to be included in the RBC numerator, what specific criteria should such additional forms of capital reasonably be required to meet to be consistent with Generally Accepted Accounting Practices (GAAP) and the Act, and why? 3. If certain forms of certificates of indebtedness were included in the risk based capital ratio numerator, what specific criteria should such certificates reasonably be required to meet to be consistent with GAAP and the Act, and why? 4. In addition to amending NCUA’s RBC regulations, what additional changes to NCUA’s regulations would be required to count additional supplemental forms of capital in NCUA’s RBC ratio numerator? 5. For state-chartered credit unions, what specific examples of supplemental capital currently allowed under state law do commenters believe should be included in the RBC ratio numerator, and why should they be included? 6. What investor suitability, consumer protection, and disclosure requirements should be put in place related to additional forms of supplemental capital? In response to these questions, a majority of the commenters who addressed supplemental capital stated that it was imperative that the Board consider allowing credit unions access to additional forms of capital. The 8 Unless otherwise noted, throughout this ANPR references to prompt corrective action, risk-based capital, and citations to Part 702 refer to Part 702 as revised by the Board at its October 2015 meeting. 9 80 FR 66626 (Oct. 29, 2015). 10 80 FR 4340, 4384 (Jan. 27, 2015). PO 00000 Frm 00002 Fmt 4702 Sfmt 4702 commenters suggested credit union authority to issue supplemental capital was particularly important as credit unions are at a disadvantage in the financial market because most lack access to additional capital outside of retained earnings. While none of the commenters offered specific suggestions on how to implement supplemental capital, a few did suggest that the Board should promulgate broad, nonprescriptive rules to allow credit unions maximum flexibility in issuing supplemental capital. As the Board did not receive comments with sufficient detail in response to the RBC proposal, the Board is again posing the six questions listed above for commenters to consider and address. Throughout this ANPR, the Board will expand on these six questions and ask more specific questions about the structure, form, regulations, and requirements related to supplemental capital, as well as relevant changes and improvements to secondary capital. The Board encourages all stakeholders to address in detail as many of these questions as possible and provide the Board with specific comments and responses. The Board intends these questions to be a starting point for commenters to present their thoughts, but invites comments on all aspects of alternative capital Throughout this ANPR the Board discusses several complex topics and uses terms to refer to specific forms of capital. In addition to supplemental, secondary, and alternative capital, the Board will use the term ‘‘regulatory capital’’ when referring to financial instruments issued by credit unions or banks, that include both equity and debt, and other financial statement account which meet the criteria contained in regulations for inclusion in the calculation of capital adequacy measures. II. Current Secondary Capital Standards The Act’s definition of net worth states that secondary capital must be ‘‘uninsured and subordinate to all other claims of the credit union, including the claims of creditors, shareholders, and the Share Insurance Fund.’’ 11 This means that any secondary capital issued by a low-income designated credit union must be the most subordinated item on the balance sheet (first loss position after retained earnings) and any losses to secondary capital must be prorated equally—that is without preference or priority. The practical effect is that low-income designated 11 12 E:\FR\FM\08FEP1.SGM U.S.C. 1790d(o)(C)(ii). 08FEP1 jstallworth on DSK7TPTVN1PROD with PROPOSALS Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules credit unions cannot include payment priority structures within or between secondary capital instruments to enhance investors’ interests. NCUA’s rules and regulations also contain various provisions addressing the prudent and appropriate issuance and use of secondary capital by lowincome designated credit unions. These provisions are as follows: • Low-income designed credit unions: Æ May only accept secondary capital accounts from non-natural person members and non-natural person nonmembers. Æ Must submit and receive approval by NCUA of a Secondary Capital Plan. Æ Must execute a Disclosure and Acknowledgement statement. • A secondary capital account: Æ Must be uninsured; Æ Have a minimum maturity of five years with a reduction in the recognition of the net worth value of accounts with less than five years of remaining maturity; Æ Must be subordinate to all other claims, including those of shareholders, creditors and the Share Insurance Fund; Æ Must be available to cover operating losses that exceed net available reserves and to extent losses are applied the accounts must not be restored; Æ Cannot be pledged by investors as security on a loan; Æ Are subject to restrictions of dividends as provided in prompt corrective action; and Æ May only in certain circumstances be redeemed early and only with prior NCUA approval.12 The regulations allow NCUA to prohibit a low-income designated credit union classified as critically undercapitalized from paying principal, dividends, or interest on secondary capital. This provision is to ensure secondary capital is available to cover losses while the low-income designated credit union is operating as a going concern. These payment restrictions are consistent with limitations on principal and interest payments imposed by the federal banking regulators for subordinated debt issued by banks.13 Further, due to the fact that secondary capital is not a permanent form of capital, NCUA’s regulations reduce the portion of secondary capital that is included in the net worth ratio as it approaches maturity. Once the remaining maturity is less than five years, the regulations require lowincome designated credit unions to discount how much a secondary capital account contributes to the credit union’s net worth value based on the following schedule: 14 natural person credit unions, and leave the provisions specific to federal credit union issuance authority in Part 701. III. Current and Prospective Use of Alternative Capital This section provides information on Remaining maturity community bank use of subordinated debt and low-income designated credit unions’ use of secondary capital. This Four to less than five years .. 80 section also provides information on the Three to less than four years 60 projected impact of risk-based capital Two to less than three years 40 standards on complex credit unions to One to less than two years .. 20 estimate the potential need for Less than one year ............... 0 supplemental capital for risk-based net worth requirement purposes. This Since 2006, low-income credit unions information provides a basis for may request NCUA approval to redeem estimating the potential for use of the portion of secondary capital no supplemental capital, the purpose of its longer included in net worth if: use, the potential purchasers, and the • The credit union will have a postrelated costs. The Board is interested in redemption net worth classification of at receiving comments concerning least adequately capitalized; projections on the volume of • The discounted secondary capital supplemental capital that credit unions has been on deposit at least two years; would be likely to issue. The Board also and seeks specific comments on the • The discounted secondary capital structures of supplemental capital will not be needed to cover losses prior instruments that would be beneficial, 15 to the final maturity date. why credit unions will issue With respect to secondary capital, the supplemental capital, and how it fits Board specifically seeks comments on into the credit union’s business model. the following: The Board is also interested in any • Whether or not to permit a lowcomments about who will purchase income designated credit union to sell supplemental capital. Since the costs secondary capital to non-institutional associated with supplemental capital investors (see Sections V and VI for are significant to the issuing credit more discussion on investor protection union, the Board seeks comments on and suitability issues), and whether this how any regulations should address the would be for members only or any issue of the cost of the instrument and party. any items that may be helpful in • Allowing for broader call options reducing the cost while maintaining for the low-income designated credit adequate protection for investors and union, other than just the portion no the Share Insurance Fund. longer counting as net worth and subject to NCUA approval, if provided for in the A. Community Bank Use of secondary capital contract. Subordinated Debt • Relaxation of pre-approval of Community bank use of subordinated issuing secondary capital if a lowdebt increased in 2016. As of June, 30, income designated credit union meets 2016, the amount outstanding was $831 certain conditions such as being at least million compared to $479 million as of adequately capitalized and having prior December 31, 2016.16 Despite the experience issuing secondary capital. increase, subordinated debt is only 0.34 • Inclusion of more flexibility to fund percent of total community bank capital. dividend payments as an operating loss The stated purpose of recent issuances if provided for in the contract. of subordinated debt by community • Any other prudential restrictions on banks generally fall into three secondary capital that should be categories: considered. • Facilitate mergers and acquisitions; • Reorganization of the regulation to • Redemption of preferred stock held improve clarity by moving to part 702 by the U.S. Treasury Department due to (Prompt Corrective Action) all matters increasing costs; and related to how the instrument must be • Fund organic growth.17 structured to qualify for capital While the interest rate paid on treatment. This would move these community bank subordinated debt can conditions to the section of NCUA rules vary significantly, generally the interest and regulations applicable to all insured Net worth value of original balance (percent) 16 FDIC 12 12 CFR 701.34. 13 12 CFR 5.47(d)(3)(ii)(B)(3). VerDate Sep<11>2014 15:10 Feb 07, 2017 Quarterly, Volume 10, Number 2, page 18. on review of a sample of SEC Form D filed by issuers. 14 Id. at § 701.34(c). 15 Id. at § 701.34(d). Jkt 241001 9693 PO 00000 Frm 00003 Fmt 4702 17 Based Sfmt 4702 E:\FR\FM\08FEP1.SGM 08FEP1 9694 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules rate is from 300 to 400 basis points over ten year treasury note rates.18 Additionally community banks report expenses associated with sales commissions, ranging from 1.25 percent to 3 percent, and fees along with legal and operational costs.19 Most buyers of bank subordinated debt are reported to be pension funds, mutual funds, other banks, and high net worth investors.20 B. Low-Income Designated Credit Union Use of Secondary Capital As of June 30, 2016, there were 2,426 low-income designated credit unions. Only 73 low-income designated credit unions (about 3 percent) report total outstanding secondary capital of $181 million.21 Since December 31, 2011, the number of low-income designated credit unions has increased by 117 percent, from 1,119 to 2,426. However, the number of low-income designated credit unions with outstanding secondary capital has ranged from 72 to 79 during this period. The $181 million in outstanding secondary capital equates to 13 percent of the total net worth of the low-income designated credit unions that issued it— with an average balance of about $2.5 million. However, outstanding secondary capital is concentrated in four low-income designated credit unions, which hold 74 percent of the total secondary capital outstanding. When excluding these four low-income designated credit unions, the average amount of secondary capital is under $700,000 per low-income designated credit union. The interest rate paid by the four largest holders of the outstanding secondary capital ranges from 0.14 percent to 3.5 percent. Secondary capital does, however, significantly benefit a low-income designated credit union’s net worth ratio. The secondary capital adds an average of nearly 300 basis points to the net worth ratio, which brings the average from just below 7 percent to near 10 percent. Out of the 73 lowincome designated credit unions with secondary capital, 66 have a net worth ratio greater than the well capitalized 7 percent level. Without the secondary capital, 25 of the 66 would have a net worth ratio less than 7 percent.22 The Board notes that low-income designated credit unions that have issued secondary capital have a higher failure rate than other low-income designated credit unions. The average annual failure rate for low-income designated credit unions with secondary capital was 2.9 percent from 2000–2013, compared to 0.8 percent for low-income designated credit unions without secondary capital during the same period.23 In a few failures of low-income designated credit unions, the assets in the credit union grew rapidly around the time the secondary capital was issued, which in turn led to higher losses to the Share Insurance Fund. NCUA has noted a pattern of poor practices in some low-income designated credit unions with secondary capital that could account for the higher failure rate, including: 24 • Poor due diligence, inaccurate cost benefit analysis and weak strategic planning in connection with establishing and expanding member service programs funded by secondary capital. • Concentrations of secondary capital to support unproven or poorly performing programs. • Failure to realistically assess and timely curtail programs not meeting expectations. • Use of secondary capital solely to delay prompt corrective action. • Insufficient liquidity to repay secondary capital at maturity. C. Potential for Credit Unions’ Use of Supplemental Capital The potential use of supplemental capital is difficult to predict due to the probable changes in market factors such as interest rates, demographics, and competition. Since supplemental capital would only increase a credit union’s risk-based capital ratio, the most likely users would be those credit unions with net worth ratios above the well capitalized level but with a risk-based capital below or near the minimum needed to be well capitalized. The following table contains an estimate of the number of credit unions likely to issue supplemental capital and the potential amount of supplemental capital that might be issued. Using Call Report data as of December 31, 2015, applied to FICUs with more than $100 million in assets,25 results in the following: Number of credit unions that do not have a low-income designation with a net worth ratio greater than 8% and an estimated risk-based capital ratio less than 13.5%. Net worth of the 140 credit unions that do not have a low-income designation with a net worth ratio greater than 8% and an estimated risk-based capital ratio less than 13.5%. Maximum amount of subordinated debt that could be issued with a limit set at 50% of net worth 26 ............................................ Amount of supplemental capital needed by the 140 to achieve a 13.5% risk-based capital ratio .................................................. jstallworth on DSK7TPTVN1PROD with PROPOSALS The Board is interested in commenter’s thoughts on whether credit unions that are not designated as lowincome use of supplemental capital could affect the availability of secondary capital for low-income designated credit unions. If so, are there any measures the Board could take to protect against this? IV. Supplemental Capital Legal Authority and Potential Taxation Implications 18 Based on review of a sample of capital market announcements and publications of completed offerings. 19 Based on review of a sample of SEC Form D filed by issuers. 20 Based on review of a sample of capital market announcements, publication of completed offerings, and SEC Form D. 21 NCUA Call Report data. 22 Secondary capital is estimated to add an average of 414 basis points to the risk-based capital ratio that will go into effect on January 1, 2019. 23 See. Secondary Capital Best Practices Guide available at https://www.ncua.gov/services/Pages/ small-credit-union-learning-center/Documents/ secondary-capital-guide.pdf. 24 Id. 25 The new risk-based net worth requirements will only apply to credit unions with assets of $100 million or more. VerDate Sep<11>2014 15:10 Feb 07, 2017 Jkt 241001 A. Risk-Based Net Worth Requirement In addition to the Act’s requirements related to the net worth ratio, the Act requires the Board to design ‘‘a riskbased net worth requirement for credit PO 00000 Frm 00004 Fmt 4702 Sfmt 4702 140. $9.2 billion. $4.5 billion. $1.0 billion. unions defined as complex.’’ 27 The riskbased net worth requirement for credit unions meeting the definition of ‘‘complex’’ was first applied on the basis of data in the Call Report as of March 31, 2001.28 Since its inception, the risk-based net worth requirement has included secondary capital issued 26 The Board would contemplate some limit on how much supplemental capital will count for riskbased capital requirements to ensure it remains a supplemental but not the primary source of capital. For illustration purposes the estimate uses a 50% limit so that it would not become the primary form of capital held by these credit unions. 27 12 U.S.C. 1790d(d)(1). 28 65 FR 44950 (July 20, 2000). E:\FR\FM\08FEP1.SGM 08FEP1 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules by low-income designated credit unions. While the Act defined the term ‘‘net worth,’’ it did not define the risk-based net worth requirement, nor how to calculate any corresponding risk-based ratio. In contrast to the narrow definition of net worth, the lack of a statutory prescription for the risk-based net worth requirement gives the Board the latitude to include within that requirement items that would not meet the statutory definition of ‘‘net worth’’ but otherwise serve as capital in protecting the Share Insurance Fund from losses when a credit union fails. Given the statutory objective of prompt corrective action ‘‘to resolve the problems of insured credit unions at the least possible long-term loss’’ to the Share Insurance Fund, the Board believes it should explore expanded options for credit unions to build capital beyond retained earnings. For a credit union defined as complex to be classified well capitalized, the Act requires the credit union to have a net worth ratio of 7 percent or greater (6 percent for adequately capitalized) and to meet the applicable risk-based net worth requirement. Starting in January 2019, the risk-based net worth requirement will require the risk-based capital ratio to be 10 percent or greater to be well capitalized (8 percent for adequately capitalized). The Act classifies a credit union as undercapitalized if it is unable to achieve the applicable risk-based net worth requirement, even if it has a high net worth ratio, thus subjecting the credit union to the corresponding prompt corrective action supervisory consequences.29 jstallworth on DSK7TPTVN1PROD with PROPOSALS B. Authority To Issue Supplemental Capital The authority for low-income designated credit unions to issue secondary capital is established in the Act. Conversely, there is no express authority for credit unions not designated as low-income to issue alternative forms of capital. However, the Act does provide federal credit unions with relatively broad authority to borrow from any source in accordance with such rules and regulations as may be prescribed by the Board.30 The Board has reviewed all applicable sections of the Act to determine the ability of federal credit unions to issue various types of financial instruments that could serve as 29 12 30 12 U.S.C. 1790d(c)(1)(C)(ii). U.S.C. 1757(9). VerDate Sep<11>2014 15:10 Feb 07, 2017 Jkt 241001 alternative capital.31 Other than as a form of debt, there is no other explicit authority in the Act for federal credit unions to issue an instrument that is uninsured and could be structured as loss absorbing capital. As a result, the Board believes only the borrowing authority is available for federal credit unions to issue supplemental capital.32 This means that federal credit unions could only issue supplemental capital as subordinated debt. However, the Board invites commenters to identify any other provisions of the Act they believe could provide alternative authority for federal credit unions to issue supplemental capital instruments other than as subordinated debt. C. Supplemental Capital Relationship to Secondary Capital Supplemental capital and secondary capital are similar in that, for federal credit unions, both are uninsured accounts issued as borrowings and subject to applicable statutory borrowing limits. Secondary capital, however, is included in the statutory definition of net worth and counts towards both the net worth ratio and the risk-based net worth requirement. Supplemental capital is not included the statutory definition of net worth and can only be considered for inclusion in the computation of the risk-based net worth requirement. Supplemental capital would have to be subordinate to the Share Insurance Fund and uninsured shareholders in the payout priorities. However, since secondary capital, per the Act, must be subordinate to all other claims, supplemental capital would be senior to secondary capital in the payout priorities. Credit unions issuing supplemental capital could be provided flexibility to include payment priority structures within or between supplemental capital instruments to enhance investors’ interests. D. Need for Comprehensive Borrowing Rule for Federal Credit Unions The Board is considering expanding the borrowing rule to clarify this authority for federal credit unions. As noted above, the Act states that federal 31 Authority to issue capital instruments for FISCUs is determined under applicable state law. 32 In December 2010, the Board issued Letter to Federal Credit Unions 10–FCU–03: Sales of Nondeposit Investments, which stated that federal credit unions are not authorized under the Act to sell nondeposit investments directly to their members. After further consideration, the Board believes federal credit unions have the authority to issue supplemental capital instruments under the borrowing authority in the Act, even though these instruments may be considered securities for purposes of state and federal securities laws. PO 00000 Frm 00005 Fmt 4702 Sfmt 4702 9695 credit unions may ‘‘borrow, in accordance with such rules and regulations as may be prescribed by the Board, from any source.’’ Currently, NCUA’s regulations only contain a rule addressing when federal credit unions borrow from natural persons. Given that the wording of the Act could suggest a federal credit union’s borrowing authority is contingent on rules and regulations prescribed by the Board, it may appear to investors that federal credit unions are restricted to only borrowing from natural persons. While the Board disagrees with this reading of the Act, the Board is concerned that some supplemental capital investors may question a federal credit union’s authority to issue supplemental capital instruments to anyone other than natural persons. Clarity and certainty about a federal credit union’s borrowing authority may be important to the sale of supplemental capital—by expanding the potential investor base and reducing unnecessary transaction complications. With respect to this topic, the Board is interested in commenter’s views on whether the Board should promulgate a more comprehensive borrowing rule as part of any authorization of supplemental capital, and what the rule should address. E. Authority for Federally Insured State Chartered Credit Unions To Issue Supplemental Capital The authority under which a federally insured state chartered credit union could issue alternative capital instruments is distinct from whether and to what extent NCUA, as insurer, would recognize it as regulatory capital for prompt corrective action purposes. A federally insured state chartered credit union’s authority to issue supplemental capital would be derived from applicable state law and regulation regarding its ability to issue liability and equity instruments. Such state laws may be narrower or broader than those for federal credit unions. Recognition as regulatory capital will depend on the characteristics of the instrument and its availability to protect the Share Insurance Fund—which would be based on uniform criteria that apply to all federally insured credit unions. (see section VI for more discussion) For federal credit unions, the Act limits the aggregate amount of borrowed funds to 50 percent of paid-in and unimpaired capital and surplus.33 Per 33 Section 700.2 of NCUA Rules and Regulations defines Paid-in and unimpaired capital and surplus as shares plus post-closing, undivided earnings. This does not include regular reserves or special reserves required by law, regulation or special E:\FR\FM\08FEP1.SGM Continued 08FEP1 9696 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules § 741.2, NCUA’s rules and regulations limit borrowing by federally insured state chartered credit unions to 50 percent of paid-in and unimpaired capital and surplus. The regulation does provide the ability for state credit unions to obtain a waiver up to the amount of borrowing allowed under state law.34 The Board is not aware of any federally insured state chartered credit unions that have requested a waiver to the borrowing limit in the past decade. While authority to issue alternative capital instruments for federally insured state chartered credit union is determined under state law, it is possible that some states will only allow their credit unions to issue alternative capital instruments under applicable borrowing authority. As NCUA’s borrowing limit for federally insured state chartered credit union is not statutory, the Board can entertain removing this limit and requests comment on this option. jstallworth on DSK7TPTVN1PROD with PROPOSALS F. Potential Taxation Implications The Board recognizes that supplemental capital could have an impact on the credit union tax exemption. The Act specifically exempts federal credit unions from taxation by the United States or by any State or local taxing authority, except real and personal property taxes.35 With respect to federal credit unions, the Board is aware that part of the basis for the credit union tax exemption was that Congress recognized most credit unions could not access the capital markets to raise capital.36 If all credit unions, not just low-income designated credit unions, have the ability to access the capital markets to meet capital standards, it could call into question one of the bases for the credit union tax exemption. The Board invites comments on this topic and would like to hear from stakeholders on the possible impact a supplemental capital rule may have on the federal credit union tax exemption. Unlike federal credit unions, the Act does not exempt federally insured state chartered credit unions from taxation. agreement between the credit union and its regulator or share insurer. 12 CFR 700.2. 34 12 CFR 741.2. 35 12 U.S.C. 1768. 36 It is noteworthy that, in 1951, thrift institutions lost their tax exemption. The Senate report to the Revenue Act of 1951 stated that mutual savings banks and savings and loan associations were losing their tax exemption because they had evolved into commercial bank competitors. In addition, thrifts had evolved from mutual organizations to ones that operated in a similar manner to banks. Finally, the exemption had given thrifts a competitive advantage over taxable commercial banks and life insurance companies. VerDate Sep<11>2014 15:10 Feb 07, 2017 Jkt 241001 Federally insured state chartered credit unions are exempt from federal income tax under § 501(c)(14)(A) of the Internal Revenue Code. Section 501(c)(14)(A) of the Internal Revenue Code provides for exemption from federal income taxes for state credit unions without capital stock organized and operated for mutual purposes without profit. At this time, there does not appear to be an established definition of ‘‘capital stock’’ used by the IRS. It is possible federally insured state chartered credit unions in some states will have broad authority to issue supplemental capital instruments that have the characteristics of capital stock, and by doing so could subject themselves to taxation. The Board therefore requests comment on whether NCUA should limit the types of instruments issued by federally insured state chartered credit unions to those that would clearly not meet the definition of capital stock. Other options the Board could consider, include requiring a federally insured state chartered credit unions to provide a formal opinion from the IRS that the supplemental capital instrument it is issuing will not be classified as capital stock or requiring the credit union to provide projections in advance of issuing the supplemental capital demonstrating that it can afford to be taxed and the benefits of the supplemental capital outweigh the cost of any taxes it might become subject to. G. Mutual Ownership Structure of Credit Unions The Board also invites comments on the potential effect supplemental capital may have on the mutual ownership structure and governance of credit unions. The Board invites comments on how it should structure any potential rule to avoid issues impacting the mutuality of credit unions, and the members’ rights to govern the affairs of the institution. Specifically, the Board invites comments on restrictions it might impose on characteristics of supplemental capital to avoid these issues, such as: Non-voting and limits on covenants in the investment agreement that may give investors levels of control over the credit union. V. Securities Law Applicability The Board believes that both secondary and supplemental capital would be considered securities for purposes of state and federal securities laws. The Board invites comment on this topic and its relationship to credit unions issuing securities as supplemental capital. Being subject to securities laws can impose requirements on the issuer to PO 00000 Frm 00006 Fmt 4702 Sfmt 4702 register with the Securities Exchange Commission (SEC), issue SEC mandated disclosures, and comply with the SEC’s broad anti-fraud rules. The Board, however, is aware that there are two exemptions that would likely be available to credit unions: • Section 3(a)(5) of the Securities Act, which is available to certain types of financial institutions, including credit unions, for the issuance of any type of security to any type of investor; 37 and • Rule 506 under Regulation D under the Securities Act, which is available to any entity offering any type of security, provided that purchasers of the securities are ‘‘accredited investors’’ (although sales to a limited number of investors who are not accredited are also possible under certain circumstances).38 While these exemptions are likely to relieve credit unions of the requirements to register with the SEC and issue SEC mandated disclosures, there are a number of other issues that credit unions must consider and comply with before issuing any instrument that would be considered a security. The Board briefly addresses each of these issues below. A. Federal Securities Requirements Regardless of any exemption from registration and disclosure, credit unions issuing alternative capital must still comply with the SEC’s broad antifraud regulations.39 The Securities Exchange Act of 1934’s (Exchange Act) general anti-fraud prohibitions are embodied in § 10(b), which generally prohibits the use of manipulative or deceptive devices or contrivances that violate SEC rules in connection with the purchase or sale of securities. Most of the litigation brought with respect to the rules promulgated under § 10(b) has been brought under the general antifraud provision, Rule 10b–5, which provides as follows: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, 37 17 CFR 240.3a5. at § 230.506. 39 See, e.g., Regulation D, Rule 501(a): ‘‘Users of Regulation D (§§ 230.500 et seq.) should note the following: (a) Regulation D relates to transactions exempted from the registration requirements of section 5 of the Securities Act of 1933 (the Act) (15 U.S.C. 77a et seq., as amended). Such transactions are not exempt from the anti-fraud, civil liability, or other provisions of the federal securities laws.’’ 38 Id. E:\FR\FM\08FEP1.SGM 08FEP1 jstallworth on DSK7TPTVN1PROD with PROPOSALS Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.40 The primary intent of Rule 10b–5 and, more broadly, the anti-fraud provisions of the Securities Act of 1933 (Securities Act) and Exchange Act, is to prevent fraud, deceit, and incorrect or misleading statements or omissions in the offering, purchase and sale of securities. Given that intent, clear and complete disclosure is the critical factor in ensuring the anti-fraud provisions of the Securities Act and Exchange Act are not breached in any offering by credit unions, regardless of whether the offering is registered with the SEC under the Securities Act or exempt from registration. In the absence of SEC-mandated disclosure delivery requirements, the practical concern for credit unions relying on either the Section 3(a)(5) or Regulation D, Rule 506 exemption is determining what type and amount of disclosure is appropriate to meet the anti-fraud standards. The Board is aware that the amount of disclosure varies depending on multiple factors, including: • The nature of the potential investors (focusing on their level of sophistication); • The nature of the security being offered (focusing on the complexity of the instrument); • The nature of the business of the issuer and the industry in which the issuer operates (focusing on the complexity of the business or industry); and • Market practices (focusing on the types of disclosure commonly provided by peer companies). In addition, the Board is aware that for any disclosure to meet the standards of Rule 10b–5, the disclosure must not contain any untrue statement of a material fact and must not omit to state a material fact, the absence of which renders any disclosure being made misleading. Further, the disclosure must be clear, accurate and verifiable, and should cover topics that are typically important to investors in making an investment decision, including: • Material risks relating to the issuer and the industry in which the issuer operates; 40 17 CFR 240.10b–5. VerDate Sep<11>2014 15:10 Feb 07, 2017 • Material risks relating to the security being offered; • The issuer’s planned uses for the proceeds of the offering; • Regulatory matters impacting the issuer and its operations; • Tax issues associated with the security being offered; and • How the securities are being offered and sold, including any conditions to be met in order to complete the offering. The Board is also aware that the Office of Comptroller of the Currency (OCC) promulgated regulations that require supervised banks issuing securities to register directly with the OCC and issue OCC mandated disclosures. The OCC mandated disclosures are very similar to those required by the SEC.41 The Board is considering requiring similar registration and disclosures for credit unions issuing alternative capital. The Board is concerned that without mandated disclosures, credit unions may be at greater risk for anti-fraud suits, which, if successful, would impair not only the credit union but also the Share Insurance Fund’s ability to use secondary or supplemental capital to cover losses. Further, the Board also believes it is important that investors in credit union alternative capital instruments have similar protections to those provided investors in SEC and OCC covered entities. The Board is interested in comments on the following questions in particular: • Should the Board require credit unions issuing alternative capital to register with NCUA? • How could NCUA protect the Share Insurance Fund against potential antifraud claims that could impair the alternative capital’s ability to cover losses? • Should the Board mandate disclosures all credit unions issuing alternative capital must provide to investors? If the Board should mandate disclosures, should it base them on the SEC’s, the OCC’s, or create a unique set of disclosures for credit unions? If the Board creates a unique set of disclosures, what should it include in those disclosures? Should the level of disclosures vary based on the level of the investor (institutional, accredited, natural person)? • Should the Board require credit unions to develop policies and procedures to ensure ongoing compliance with anti-fraud requirements before it begins issuing alternative capital? The Board is also aware that there may be potential broker-dealer 41 12 Jkt 241001 PO 00000 Fmt 4702 registration issues related to secondary and supplemental capital. Specifically, marketing activities by a credit union and its employees could require the credit union to register as a brokerdealer. While there are exemptions available to credit unions and their employees, the Board notes that these exemptions are complex and require a thorough evaluation of a credit union’s practices and the activities of its employees. If a credit union or its employees fail to qualify for an exemption, the credit union or employee could be required to register as a broker-dealer or face penalties for failure to comply with applicable rules. The Board has previously stated that federal credit unions are not permitted to register as broker-dealers.42 The Board invites comments on how it should ensure a credit union has determined if it or its employees are required to register. In addition, it is unlikely that credit unions and their employees would be subject to investment adviser registration requirements. The Board notes that certain marketing activities and relationships with other credit unions could raise investment adviser requirements. The Board, therefore, invites comments on this issue and if NCUA should require credit unions to have policies and procedures to ensure their activities do not trigger investment adviser registration requirements. B. State Securities Requirements First, certain provisions of the Securities Act and SEC rules have preempted state securities laws with respect to most covered securities. However, states may require issuers to register with the state and/or pay state registration fees. Further, states may also pursue fraud-based claims. The Board invites comment on how it should ensure that any credit union issuing alternative capital has considered and complied with all applicable state laws. C. Director and Officer Liability Coverage The Board also notes that issuing securities can affect a credit union’s director and officer liability coverage. A lack of coverage could not only impair the credit union, but also threaten the Share Insurance Fund in the event there are losses that the credit union is ultimately responsible for. Before engaging in supplemental or secondary capital activities, therefore, credit unions will need to evaluate coverage to 42 NCUA Letter to FCUs 10–FCU–03, Sale of Nondeposit Investments, December 2010. CFR part 16. Frm 00007 9697 Sfmt 4702 E:\FR\FM\08FEP1.SGM 08FEP1 9698 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules ensure these activities are covered under their policy. The Board requests comments on if it should mandate that credit unions certify that they have evaluated their policies and have sufficient coverage before beginning secondary or supplemental capital activities. jstallworth on DSK7TPTVN1PROD with PROPOSALS D. Contractual Matters and Communications A credit union will need to address contractual provisions between the credit union and its investors. Often these provisions will include requiring ongoing communications with investors, reporting of compliance with the contractual covenants, and sharing of information with current and prospective investors. Credit unions will have to develop policies and procedures to comply with these covenants and provisions and ensure that they are not providing non-public information to investors that is not generally available to all investors. Failure to comply with the investment contracts or to properly monitor communications and sharing of information could subject the credit union to liability, which could negatively impact the Share Insurance Fund. As such, the Board requests comment on if it should mandate comprehensive policies addressing compliance with investment contracts, communications, and information sharing. The Board invites commenters to provide suggestions on the specific details that should be in the policy and if sufficient policies should be a prerequisite to engaging in supplemental or secondary capital activities. VI. Other Investor Considerations Section 701.34(b) of NCUA’s regulations limits eligible investors in secondary capital to institutional investors, referenced as non-natural persons.43 This limitation is not required by the Act. This limitation prevents the sale of secondary capital to consumers who could lack the ability to understand the risks associated with secondary capital, especially when there is opportunity for confusion given that the low-income designated credit union is federally insured. Also, low-income designated credit unions can sell secondary capital to nonmembers. When the secondary capital regulations were written in 1996 the purchasers of secondary capital were presumed to be foundations and other philanthropicminded institutional investors.44 43 12 44 61 CFR 701.34(b). FR 378 (Feb. 2, 1996). VerDate Sep<11>2014 15:10 Feb 07, 2017 From an investor protection standpoint, the issue of limiting the sale of secondary capital and supplemental capital largely focuses on providing adequate protections to the purchasers through the issuance of initial disclosures, transparency standards with respect to reporting of information about the operations and performance of the credit union, and whether the purchaser has the necessary sophistication relative to the complexity and risk of the instrument. As discussed in more detail in the Section V, Securities Law Applicability, of this ANPR, the OCC requires banks issuing subordinated debt to comply with the securities offering disclosure rules in its regulations.45 The OCC’s regulations establish registration statement and prospectus requirements for the offer and sale of securities issued, subject to exemptions and disclosure requirements based on the sophistication of the investor. As banks are not restricted in who they can sell securities to, these rules, in part, help provide a level of investor protection, particularly for less sophisticated, non-institutional investors. The issue of permissible investors is also related to anti-fraud considerations. As noted above, the level of disclosures necessary to comply with anti-fraud rules varies, in part, on the level of sophistication of the investors. In practice, selling to non-sophisticated investors would likely involve a much higher initial and ongoing disclosure and communications burden for credit unions. Thus, the Board requests comment on whether the sale of secondary and supplemental capital should be limited to only institutional investors, include accredited investor, or allow for anyone to purchase. If the Board were to allow credit unions to sell alternative capital to non-accredited investors, should there be limits on the amount individual investors can purchase? Also, should there be conditions on how the sale to non-accredited investors must be handled to minimize potential confusion about its lack of federal insurance? Whether credit unions that are not low-income designated should be able sell supplemental capital instruments to nonmembers with equity like characteristics is a matter relevant to considerations about the mutual model of credit unions. The Board requests comments on the extent to which credit unions should be allowed to sell alternative capital with equity like characteristics to nonmembers, and if 45 12 Jkt 241001 PO 00000 CFR 5.47(d)(3)(iii). Frm 00008 Fmt 4702 Sfmt 4702 so, what controls are necessary to preserve the mutual ownership structure and democratic governance of credit unions. The Board invites comments on how it should structure any potential rule to avoid issues impacting the mutuality of credit unions, and the members’ rights to govern the affairs of the institution. VII. Prudential Standards for Issuing and Counting Alternative Capital for Prompt Corrective Action For a financial instrument to be considered regulatory capital for prompt corrective action purposes, NCUA must consider the instrument’s degree of permanence, capacity to absorb losses as a going concern, the flexibility of principal and interest payments, and intended use of the proceeds. These characteristics are consistent with the Basel Tier 2 capital criteria.46 These same criteria are also contained in the regulatory capital quality distinctions for the U.S. banking system.47 Provisions related to these characteristics are intended to ensure the funds will be available to protect the Share Insurance Fund and do not create incentives for credit unions to engage in unsafe or unsound practices. The function of supplemental capital is to protect the credit union and the Share Insurance Fund in the event of loss. Supplemental capital, therefore, must be able to absorb losses ahead of the Share Insurance Fund while not conferring control of the credit union to the investor. The instruments must be uninsured and cannot be guaranteed or secured by the credit union or its assets. These features ensure supplemental capital fulfils its ultimate purpose and does not result in unintended encumbrances to the credit union or the Share Insurance Fund. The degree of permanence is important because the instrument must create sufficient stability in the credit union’s capital base to be available to cover losses over a long time period. This is the reason for the minimum five year maturity contained in the Basel accords, the U.S. banking capital regulations, and for secondary capital 46 Basel III was published in December 2010 and revised in June 2011. The text is available at http:// www.bis.org/publ/bcbs189.htm. The BCBS is a committee of banking supervisory authorities, which was established by the central bank governors of the G–10 countries in 1975. More information regarding the BCBS and its membership is available at http://www.bis.org/bcbs/ about.htm. Documents issued by the BCBS are available through the Bank for International Settlements Web site at http://www.bis.org. See paragraph number 58 for criteria for inclusion in Tier 2 Capital. 47 12 U.S.C. 324.20. E:\FR\FM\08FEP1.SGM 08FEP1 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules for low-income designated credit unions. With respect to secondary capital, a low-income designated credit unions is allowed to have a call option for the portion no longer qualifying as net worth so that they may retire the instrument if it is no longer needed or market conditions allow them to reprice the capital at a lower rate. However, supervisory approval is needed before any call is exercised because it represents a potentially material change to the risk to the Share Insurance Fund. The alternative capital must be able to absorb losses while the institution is still a going concern, and not just in the case of liquidation. The existing regulatory language regarding secondary capital requires that it is available to ‘‘cover operating losses.’’ 48 The term ‘‘operating losses’’ has been interpreted to not include the payment of dividends on shares.49 However, a credit union’s inability to fund a dividend rate that is consistent with prevailing rates can create liquidity and reputation risk. Therefore, credit unions may need the flexibility to issue alternative capital instruments that are available to absorb all losses in excess of retained earnings, including the payment of dividends on shares.50 The Board is seeking comment on the exclusion of dividend expenses as an operating expense and seeks comment on how to resolve the complexity that can result from excluding dividend expense from losses applied to secondary capital but not from losses applied to supplemental capital. Further, the payment of interest on the instruments must be capable of being cancelled on a permanent, noncumulative basis without constituting a default. The interest provisions must also not contain any feature which would provide incentive for the credit union to exercise a call option, such as a large increase in the interest rate. The flexibility of payments ensures investors cannot obviate any risk exposure to their principal through problematic dividend and interest provisions. These criteria are consistent with the criteria for inclusion in Tier 2 capital used by the other banking regulators 51 and are contained in Basel III.52 jstallworth on DSK7TPTVN1PROD with PROPOSALS 48 12 CFR 701.34(b)(7). CFR 701.34. 50 If the Board authorizes supplemental capital, it could be possible for low income designated credit unions to concurrently offer both supplemental and secondary capital instruments. The differing treatment of payments on dividends could make the administration of losses applied to alternative capital complex and potentially confusing. 51 12 CFR 5.47. 52 Basel III was published in December 2010 and revised in June 2011. The text is available at http:// 49 12 VerDate Sep<11>2014 15:10 Feb 07, 2017 Jkt 241001 Because of these characteristics, most alternative capital instruments can have relatively low liquidity for the purchaser and there is no guarantee of a secondary market. These characteristics also impact the interest rate the credit union must pay for alternative capital. The Board seeks comment on how to maintain protection of the Share Insurance Fund while minimizing the impact the criteria would have on the cost and marketability of the alternative capital instruments. A. Approval To Issue and Notice The Board is considering including an application and notice requirement in any supplemental capital regulations it may issue.53 The Board notes that requiring a credit union to obtain approval to issue alternative capital and provide a notice of issuance can contribute to ensuring alternative capital instruments are issued in accordance with applicable regulations, part of a sound management plan, and are structured to properly protect the Share Insurance Fund.54 The Board notes that currently NCUA requires a low-income designated credit union to submit a ‘‘Secondary Capital Plan’’ prior to the acceptance of secondary capital that includes: 55 • The maximum aggregate amount of secondary capital the low-income designated credit union plans to accept; • The purpose for which the secondary capital will be used and how it will be repaid; • Demonstration that the uses of the secondary capital conform to the lowincome designated credit union’s strategic plan, business plan, and budget; and • Supporting pro forma financial statements covering a minimum of two years. The account agreement associated with any alternative capital needs to conform to the standards that ensure it protects the Share Insurance Fund and provide the credit union with flexibility in conducting its daily affairs. The secondary capital regulation currently requires that the low-income designated credit union retain the original account agreement and the ‘‘Disclosure and Acknowledgment’’ for the term of the www.bis.org/publ/bcbs189.htm. See paragraph 58 for criteria for inclusion in Tier 2 Capital. 53 Secondary capital provisions already require low income designated credit unions to obtain prior NCUA approval. 54 See. 12 CFR 5.47(f) and (h) for the OCC’s requirements for prior approval for issuance of subordinated debt and for the notice procedure for inclusion as tier 2 capital. 55 12 CFR 701.34(b)(1). PO 00000 Frm 00009 Fmt 4702 Sfmt 4702 9699 agreement.56 The regulation does not specifically require a low-income designated credit union to submit to NCUA either a draft account agreement with the application or the executed agreement. For all forms of alternative capital, the Board seeks comments on the utility of a prior approval process and a postissuance notification process. The Board can also consider under what conditions prior approval would not be necessary, such as credit unions that are well capitalized with a successful history of issuing alternative capital. When prior approval would be necessary, however, the Board requests comments on what should be required in an application for authority to issue alternative capital, and how long the credit union would have to issue the alternative capital after approval. In addition, the Board request comment on the evaluation criteria NCUA should use to approve or deny the application, including whether or not certain credit unions that are already in danger of failing should be precluded from issuing alternative capital as a form of investor protection. Also, the Board seeks comment on the manner of and what should be included in any post-issuance notice credit unions would file with NCUA. B. Subordination Secondary capital must be subordinate to all other claims per the Act.57 Thus, supplemental capital must have a payout priority senior to secondary capital but still subordinate to the Share Insurance Fund. The requirement that alternative capital instruments are subordinate to the Share Insurance Fund, uninsured shareholders, and general creditors is consistent with the Basel criteria for Tier 2 capital.58 Unlike secondary capital, supplemental capital is not subject to provisions in the Act that limit flexibility in structuring payment priorities within and between supplemental capital instruments. For example, a credit union could issue a supplemental capital instrument with 56 Id. at § 701.34(b)(11). U.S.C. 1790d(o)(2)(C)(ii). 58 Basel III was published in December 2010 and revised in June 2011. The text is available at http:// www.bis.org/publ/bcbs189.htm. The BCBS is a committee of banking supervisory authorities, which was established by the central bank governors of the G–10 countries in 1975. More information regarding the BCBS and its membership is available at http://www.bis.org/bcbs/ about.htm. Documents issued by the BCBS are available through the Bank for International Settlements Web site at http://www.bis.org. See paragraph number 58 for criteria for inclusion in Tier 2 Capital. 57 12 E:\FR\FM\08FEP1.SGM 08FEP1 9700 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules two tranches, a high-yield-high-risk supporting tranche and a loweryielding-lower risk tranche. Credit unions could also issue supplemental capital instruments that have first infirst out, or last in-first out contractual payment priorities. This flexibility could help credit unions attract investors of different risk tolerances and profiles. The Board seeks comment on whether authorizing supplemental capital regulations should contain any restrictions on payment priority options, and if so, what should they be. C. Limit on Amount of Supplemental Capital That Counts as Regulatory Capital While supplemental capital can protect the Share Insurance Fund and uninsured shares from losses, reliance on alternative capital as the primary source of capital is generally unsafe and unsound. Even with a high level of permanent capital, such as retained earnings and common stock, heavy reliance on alternative capital can result in wide fluctuations in capital measures due to the timing of its maturity and negative impact on earnings due to the associated costs. U.S. bank capital regulations require banks to hold minimum levels of common equity tier 1 capital, total tier 1 capital, and total tier 1 and tier 2 capital to total risk assets that ensures that permanent capital is generally the primary source of regulatory capital.59 An FDIC-supervised institution must maintain the following minimum capital ratios: 60 • A common equity tier 1 capital ratio of 4.5 percent; • A tier 1 capital ratio of 6 percent; • A total capital ratio of 8 percent; and • A leverage ratio of 4 percent.61 Additionally to be classified as well capitalized a bank must have: 59 12 CFR 324.10(a). standardized capital ratio calculations are defined in 12 CFR 3.10(b). The Common Equity Tier 1 Capital Ratio is the ratio of Common Equity Tier 1 Capital to standardized total risk-weighted assets. The Tier 1 Capital Ratio is the ratio of Tier 1 Capital to standardized total risk-weighted assets. The Total Capital Ratio is the ratio of total capital (Tier 1 Capital plus Tier 2 Capital) to standardized total risk-weighted assets. The Leverage Ratio is generally Tier 1 Capital to total consolidated assets. The components of regulatory capital are defined in 12 CFR 3.20. Common Equity Tier 1 Capital is generally common stock, retained earnings, and accumulated other comprehensive income. Additional Tier 1 Capital primarily includes noncumulative perpetual preferred stock. Tier 2 Capital generally includes limited allowance for loan and lease losses, certain subordinated debt and preferred stock, and qualifying capital minority interests. 61 Id. at § 324.10(a). jstallworth on DSK7TPTVN1PROD with PROPOSALS 60 The VerDate Sep<11>2014 15:10 Feb 07, 2017 Jkt 241001 • A total risk-based capital ratio of 10.0 percent or greater; • A Tier 1 risk-based capital ratio of 8.0 percent or greater; • A common equity tier 1 capital ratio of 6.5 percent or greater; and • A leverage ratio of 5.0 percent or greater.62 As a result, banks are inherently limited in how much Tier 2 forms of capital will be included in meeting their regulatory capital standards. Most forms of alternative capital likely available to credit unions will be in the form of subordinated debt—which does not meet the standards to qualify as Tier 1 capital. Neither the Act nor NCUA regulations limit the amount of secondary capital that can make up a low income designated credit union’s net worth. Given their unique needs and mission, low-income designated credit unions can primarily rely on secondary capital to meet prompt corrective action requirements, provided their use of the proceeds and overall ongoing management of their secondary capital is otherwise safe and sound. However, the Board believes any regulation for supplemental capital needs to contain some method of preventing supplemental capital, a lower quality of capital, from becoming the primary component of regulatory capital for credit unions. The Board seeks comments on how capital regulations could be designed to limit the amount of supplemental capital included in regulatory capital calculations. Consistent with Basel, U.S. bank capital standards,63 and secondary capital regulations, the portion of supplemental capital that would be considered as regulatory capital and included in the calculation of the riskbased net worth requirement would be subject to reductions during the last five years of the life of the instrument. Consistent with secondary capital, at the beginning of the each of last five years of the life of the supplemental capital, the amount that is eligible to be included in the risk-based net worth requirement would be reduced by 20 percent of the original amount of the instrument (less any redemptions that may have occurred). The Board seeks comments on this concept and how to reflect the increasingly limited utility as loss absorbing capital for supplemental capital approaching maturity. The Board also notes that changing conditions and circumstances may warrant early repayment of alternative capital, in part or in whole. The decision on early repayment must reside with the issuing credit union and not the holder of the instrument, to ensure the permanence of the instrument and prevent undue influence by investors. Currently the secondary capital regulations only allow for early redemption of the amount of secondary capital that is not recognized as net worth, with approval by NCUA.64 Regulatory controls over early repayment are necessary to protect the Share Insurance Fund and uninsured shares. Regulatory controls over early repayment are also consistent with the Basel framework for subordinated debt and the other banking agencies’ regulations, which provide control over the early repayment of subordinated debt by: • Requiring all banks to obtain prior approval to prepay or call subordinated debt included in tier 2 capital.65 • Prohibiting the holder of subordinated debt from having a contractual right to accelerate principal or interest payments in the instrument, except in the event of a receivership, insolvency, liquidation, or other similar proceeding.66 • Prohibiting the exercise of a call option in the first five years following issuance, except in certain very limited circumstances. Enabling regulations for supplemental capital will need to address the issue of prepayment and call provisions for supplemental capital. The options regarding the abilities of a credit union to prepay supplemental capital could include minimum capital measures after repayment, current and expected future performance measures and notice criteria of varying degrees. The Board invites comments on the topic of prepayment and call provisions for alternative capital and how it should structure any related requirements. Allowing credit unions greater flexibility to eliminate the cost of alternative capital or reprice the instrument under better terms could provide benefits to the credit union. Any alternative to the redemption process would be contingent on the credit union no longer relying on the alternative capital to achieve an appropriate level of capital. D. Reciprocal Holdings Regulations for alternative capital need to address reciprocal holdings. Reciprocal holdings exist when two or more credit unions hold each other’s alternative capital. Reciprocal holdings 64 12 CFR 701.34(d). at § 5.47(d)(1)(vii). 66 Id. at § 5.47(d)(2). 62 Id. at § 324.403(b)(1). 63 12 CFR 324.20(d)(iv). PO 00000 Frm 00010 Fmt 4702 65 Id. Sfmt 4702 E:\FR\FM\08FEP1.SGM 08FEP1 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules of alternative capital, without some form of adjustment, would artificially inflate the level of capital in the credit union system, create loss transmission channels between credit unions, and could be subject to abuse. The Board notes a national bank or federal savings association must deduct investments in the capital of other financial institutions it holds reciprocally, where such reciprocal cross holdings result from a formal or informal arrangement to swap, exchange, or otherwise intent to hold each other’s capital instruments, by applying the corresponding deduction approach.67 The Board requests comment on how NCUA should address this concern. jstallworth on DSK7TPTVN1PROD with PROPOSALS E. Merger Per the current regulation, in the event of merger of a low-income designated credit union (other than merger into another low-income designated credit union) the secondary capital accounts will be closed and paid out to the investor to the extent they are not needed to cover losses at the time of merger or dissolution. The OCC prohibits a covenant or provision in subordinated debt instruments that requires the prior approval of a purchaser or holder of the subordinated debt note in the case of a voluntary merger where the resulting institution assumes the due and punctual performance of all conditions of the subordinated debt note and where the agreement is not in default of the various other covenants.68 In order to avoid any perceptions of an alternative capital holder having ownership rights, any restrictions on merger or other change of control must not interfere with the credit union’s ability to exercise its business judgement and management of the credit union in a manner that avoids unsafe and unsound practices. The Board seeks comment on the issue of merging credit unions and how alternative capital should be treated post-merger. F. Other Restrictions Supplemental capital must not contain contractual terms that would limit or impede the authority of NCUA or a State Supervisory Authority to undertake supervisory action, as necessary, to protect the issuing credit union’s members or the Share Insurance Fund. Any such contractual terms would impose unsafe and unsound limits on the credit union’s and 67 12 68 12 CFR 3.22(c)(3). CFR 5.47(d)(2)(iv). VerDate Sep<11>2014 15:10 Feb 07, 2017 regulators’ ability to manage the institution and address problems. Affirmative covenants within the supplemental capital note or agreement must not restrict operations or potentially require a credit union to violate a law or regulation. Negative covenants should not unreasonably impair the credit union’s flexibility in conducting its operations or interfere with management. Without these restrictions, contractual terms could undermine the purpose of supplemental capital and provide holders of these obligations with unintended rights and control over the credit union’s operations. Any representation or warranties contained in the agreements that would require acceleration and repayment of the subordinated debt note because of a technical violation that does not reflect underlying credit issues could be contrary to safety and soundness. The Board seeks comments on the issue of contractual restrictions for alternative capital instruments. VIII. Supporting Regulatory Changes A. 701.32—Payment on Shares by Public Unit Nonmembers Due to the potential use of alternative capital as a funding source similar to public units and nonmembers, the NCUA Board is seeking comment on § 701.32 of NCUA’s regulations as it prescribes limits placed on these accounts. Section 1757(6) of the FCU Act grants federal credit unions the power ‘‘to receive from its members, from other credit unions, from an officer, employee, or agent of those nonmember units of Federal, Indian tribal, State, or local governments and political subdivisions thereof enumerated in section 1787 of this title and in the manner so prescribed, from the Central Liquidity Facility, and from nonmembers in the case of credit unions serving predominately low-income members (as defined by the Board) payments, representing equity, on—(A) shares which may be issued at varying dividend rates; (B) share certificates which may be issued at varying dividend rates and maturities; and (C) share draft accounts authorized under section 1785(f) of this title; subject to such terms, rates, and conditions as may be established by the board of directors, within limitations prescribed by the Board.’’ 69 Currently the regulation limits total public unit and nonmember shares to 20 percent of the total shares of the federal credit union or $3 million, whichever is 69 12 Jkt 241001 PO 00000 U.S.C. 1785(f). Frm 00011 Fmt 4702 Sfmt 4702 9701 greater.70 Federal credit unions seeking to exceed the limit must: • Adopt a specific written plan concerning the intended use of these shares and provide it to the Regional Director before accepting the funds; and • Submit a written request to the Regional Director for a new maximum level of public unit and nonmember shares.71 Under § 741.204, federally insured state chartered credit unions must adhere to the requirements of § 701.32 regarding public unit and nonmember accounts.72 This regulation also addresses a federally insured state chartered credit union obtaining a lowincome designation, as provided under state law, in order to accept nonmember accounts other than from public units or other credit unions.73 Additionally this section addressed the ability of a federally insured state chartered credit union to receive and redeem secondary capital consistent with § 701.34 and consistent with applicable state law and regulation.74 Because the limitations the NCUA board may prescribe to these accounts is not statutory, the NCUA Board is interested in comments on revisions to this regulation which would reduce the regulatory burden of the waiver process but still provide for adequate protection of the Share Insurance Fund. B. 701.34—Designation of Low-Income Status; Acceptance of Secondary Capital Accounts by LICUs Section 701.34 of NCUA’s Rules and Regulations sets out the requirements and process for a credit union to receive a low-income designation, the criteria for accepting secondary capital and the inclusion of secondary capital as regulatory capital. NCUA is seeking comment on whether the criteria and process for obtaining the low income designation, the criteria for issuing secondary capital, and the criteria for inclusion of secondary capital as regulatory capital should be in separate regulations. Section 701.34 could be solely focused on the process to receive a lowincome designation. A new section of 701 could be used to address: • The authority and requirements of secondary capital; • Grandfathering treatment of existing secondary capital in the event of regulatory changes; 70 12 CFR 701.32(b)(1). at § 701.32(b)(2). 72 Id. at § 741.204(a). 73 Id. at § 741.204(b). 74 Id. at § 741.204(c) and (d). 71 Id. E:\FR\FM\08FEP1.SGM 08FEP1 9702 Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 / Proposed Rules • Requirement to comply with all applicable federal and state laws in the issuance of secondary capital; • Requirements for written contract agreements covering the terms and conditions of the secondary capital; • Requirements for disclosures and acknowledgement; • Investor suitability; and • Prohibitions. The items specific to secondary capital’s and supplemental capital’s inclusion in regulatory capital and related capital adequacy issues could be consolidated into Section 702—Capital Adequacy, including: • Standards for alternative capital instruments to be counted as regulatory capital; • Any limits on the amount of alternative capital counted as regulatory capital; • The role of supplemental capital in approval of a net worth restoration plan; • Provisions for discounting regulatory capital treatments such as violations of applicable laws or regulation, including any deficiency cure alternatives; and • Risk weight for an investment in supplemental capital. C. Payout Priorities To conform the regulatory payout priorities for supplemental capital, the payout priorities for an involuntary liquidation will need to be revised.75 Supplemental capital would be listed in the payout priority after uninsured shareholders and the Share Insurance Fund. jstallworth on DSK7TPTVN1PROD with PROPOSALS D. Other Regulations The Board seeks comments on any other related changes to existing regulations, such as: • Modifying the definition of insured shares in 741.4(b) to exclude any equity shares allowed under state law, if they are in fact uninsured; • Modifying 741.9 to provide for the existence of uninsured accounts issued under state law by FISCUs; and • Any cohering changes to part 745 as necessary. By the National Credit Union Administration Board on January 19, 2017. Gerard Poliquin, Secretary of the Board. [FR Doc. 2017–01713 Filed 2–7–17; 8:45 am] BILLING CODE P 75 12 CFR 709.5. VerDate Sep<11>2014 17:23 Feb 07, 2017 Jkt 241001 DEPARTMENT OF ENERGY Federal Energy Regulatory Commission 18 CFR Part 40 [Docket No. RM16–20–000] Remedial Action Schemes Reliability Standard Federal Energy Regulatory Commission. ACTION: Notice of proposed rulemaking. AGENCY: The Federal Energy Regulatory Commission proposes to approve Reliability Standard PRC–012– 2 (Remedial Action Schemes) submitted by the North American Electric Reliability Corporation. The purpose of proposed Reliability Standard PRC– 012–2 is to ensure that remedial action schemes do not introduce unintentional or unacceptable reliability risks to the bulk electric system. DATES: Comments are due April 10, 2017 SUMMARY: Comments, identified by docket number, may be filed in the following ways: • Electronic Filing through http:// www.ferc.gov. Documents created electronically using word processing software should be filed in native applications or print-to-PDF format and not in a scanned format. • Mail/Hand Delivery: Those unable to file electronically may mail or handdeliver comments to: Federal Energy Regulatory Commission, Secretary of the Commission, 888 First Street, NE., Washington, DC 20426. Instructions: For detailed instructions on submitting comments and additional information on the rulemaking process, see the Comment Procedures Section of this document. FOR FURTHER INFORMATION CONTACT: Syed Ahmad (Technical Information), Office of Electric Reliability, Division of Reliability Standards and Security, 888 First Street NE., Washington, DC 20426, Telephone: (202) 502–8718, Syed.Ahmad@ferc.gov. Alan Rukin (Legal Information), Office of the General Counsel, Federal Energy Regulatory Commission, 888 First Street NE., Washington, DC 20426, Telephone: (202) 502–8502, Alan.Rukin@ferc.gov. SUPPLEMENTARY INFORMATION: 1. Pursuant to section 215 of the Federal Power Act (FPA), the Commission proposes to approve proposed Reliability Standard PRC– 012–2 (Remedial Action Schemes). The North American Electric Reliability ADDRESSES: PO 00000 Frm 00012 Fmt 4702 Sfmt 4702 Corporation (NERC), the Commissioncertified Electric Reliability Organization (ERO), submitted proposed Reliability Standard PRC–012–2 for approval. The purpose of proposed Reliability Standard PRC 012–2 is to ensure that remedial action schemes (RAS) do not introduce unintentional or unacceptable reliability risks to the bulk electric system. In addition, the Commission proposes to approve the associated violation risk factors and violation severity levels, implementation plan, and effective date proposed by NERC. NERC also submitted proposals to retire two currently-effective Reliability Standards and to withdraw three Reliability Standards that are pending review before the Commission. While proposing to approve Reliability Standard PRC–012–2, the Commission seeks clarifying comments addressing ‘‘limited impact’’ RAS. Based on comments and information received, the Commission may issue directives as appropriate. I. Background A. Section 215 and Mandatory Reliability Standards 2. Section 215 of the FPA requires a Commission-certified ERO to develop mandatory and enforceable Reliability Standards, subject to Commission review and approval.1 Once approved, the Reliability Standards may be enforced by the ERO subject to Commission oversight, or by the Commission independently.2 In 2006, the Commission certified NERC as the ERO pursuant to section 215 of the FPA.3 B. Order No. 693 3. On March 16, 2007, the Commission issued Order No. 693, approving 83 of the 107 Reliability Standards filed by NERC, including Reliability Standards PRC–015–1 (Remedial Action Scheme Data and Documentation) and PRC–016–1 (Remedial Action Scheme Misoperation).4 Reliability Standard PRC–015–1 requires transmission owners, generator owners, and distribution providers to maintain a 1 16 U.S.C. 824o(c), (d) (2012). 824o(e). 3 North American Electric Reliability Corp., 116 FERC ¶ 61,062 (ERO Certification Order), order on reh’g and compliance, 117 FERC ¶ 61,126 (2006), order on compliance, 118 FERC ¶ 61,190, order on reh’g, 119 FERC ¶ 61,046 (2007), aff’d sub nom. Alcoa Inc. v. FERC, 564 F.3d 1342 (D.C. Cir. 2009). 4 Mandatory Reliability Standards for the BulkPower System, Order No. 693, FERC Stats. and Regs. ¶ 31,242, order on reh’g, Order No. 693–A, 120 FERC ¶ 61,053 (2007). 2 Id. E:\FR\FM\08FEP1.SGM 08FEP1

Agencies

National Credit Union Administration

[Federal Register Volume 82, Number 25 (Wednesday, February 8, 2017)]
[Proposed Rules]
[Pages 9691-9702]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-01713]

========================================================================
Proposed Rules
Federal Register
________________________________________________________________________

This section of the FEDERAL REGISTER contains notices to the public of
the proposed issuance of rules and regulations. The purpose of these
notices is to give interested persons an opportunity to participate in
the rule making prior to the adoption of the final rules.

========================================================================

Federal Register / Vol. 82, No. 25 / Wednesday, February 8, 2017 /
Proposed Rules

[[Page 9691]]

NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 701, 702, 703, 709, 741, and 745

Alternative Capital

AGENCY: National Credit Union Administration.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: The NCUA Board (Board) is issuing this advanced notice of
proposed rulemaking (ANPR) to solicit comments on alternative forms of
capital federally insured credit unions could use in meeting capital
standards required by statute and regulation. For purposes of this
ANPR, alternative capital includes two different categories: Secondary
capital and supplemental capital. Secondary capital is currently
permissible under the Federal Credit Union Act (Act) only for low-
income designated credit unions to issue and to be counted toward both
the net worth ratio and the risk-based net worth requirement of NCUA's
prompt corrective action standards. The Board is considering changes to
the secondary capital regulation for low-income designated credit
unions. There are no other forms of alternative capital currently
authorized. However, the Board is also considering whether or not to
authorize credit unions to issue supplemental capital instruments that
would only count towards the risk-based net worth requirement.

DATES: Comments must be received on or before May 9, 2017.

ADDRESSES: You may submit comments by any one of the following methods
(Please send comments by one method only):
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Email: Address to regcomments@ncua.gov. Include ``[Your
name]--Comments on Advance Notice of Proposed Rulemaking for
Supplemental Capital'' in the email subject line.
Fax: (703) 518-6319. Use the subject line described above
for email.
Mail: Address to Gerald Poliquin, Secretary of the Board,
National Credit Union Administration, 1775 Duke Street, Alexandria,
Virginia 22314-3428.
Hand Delivery/Courier: Same as mail address.
Public Inspection: You can view all public comments on NCUA's Web
site at http://www.ncua.gov/Legal/Regs/Pages/PropRegs.aspx as
submitted, except for those we cannot post for technical reasons. NCUA
will not edit or remove any identifying or contact information from the
public comments submitted. You may inspect paper copies of comments in
NCUA's law library at 1775 Duke Street, Alexandria, Virginia 22314, by
appointment weekdays between 9 a.m. and 3 p.m. To make an appointment,
call (703) 518-6546 or send an email to OGCMail@ncua.gov.

FOR FURTHER INFORMATION CONTACT: Steve Farrar, Supervisory Financial
Analyst, at (703) 518-6360; or Justin Anderson, Senior Staff Attorney,
Office of General Counsel, at (703) 518-6540. You may also contact them
at the National Credit Union Administration, 1775 Duke Street,
Alexandria, Virginia 22314.

SUPPLEMENTARY INFORMATION: At its October 2016 meeting, the Board held
a public briefing on the topic of alternative capital for credit
unions. This ANPR provides relevant background information and seeks
comment on a broad range of considerations with respect to alternative
capital for federally insured credit unions. This ANPR addresses topics
including: (1) NCUA's authority to include alternative capital for
prompt corrective action purposes; (2) credit unions' authority to
issue alternative forms of capital; (3) prudential standards regarding
the extent to which various forms of instruments would qualify as
capital for prompt corrective action purposes and credit union
eligibility for the sale of alternative capital; (4) the utility and
suitability of supplemental capital for credit unions; (5) standards
for investor protection, including disclosure requirements and investor
eligibility criteria for the purchase of alternative capital; (6)
implications of securities law for supplemental and secondary capital;
(7) potential implications for credit unions, including the credit
union tax exemption; and (8) overall regulatory changes the Board would
need to make to permit supplemental capital, improve secondary capital
standards, and provide or modify related supporting authorities. The
Board has posed a number of specific questions on these and other
topics, but invites comments on any and all aspects of alternative
capital.

I. Background
II. Current Secondary Capital Standards
III. Current and Prospective Use of Alternative Capital
IV. Supplemental Capital Legal Authority and Potential Taxation
Implications
V. Securities Law Applicability
VI. Other Investor Considerations
VII. Prudential Standards for Issuing and Counting Alternative
Capital for Prompt Corrective Action
VIII. Supporting Regulatory Changes

I. Background

In 1998, Congress passed the Credit Union Membership Access Act
(CUMAA) which amended the Act to mandate a system of prompt corrective
action for federally insured natural person credit unions (credit
unions).\1\ The prompt corrective action system incorporates capital
standards for credit unions. The Act indexes a credit union's prompt
corrective action status to five categories: Well capitalized,
adequately capitalized, undercapitalized, significantly
undercapitalized, and critically undercapitalized.\2\ As a credit
union's capital level falls, its classification among the prompt
corrective action categories can decline below well capitalized, thus
exposing it to an expanding range of mandatory and discretionary
supervisory actions designed to remedy the problem and minimize any
loss to the National Credit Union Share Insurance Fund (Share Insurance
Fund).\3\
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\1\ The Credit Union Membership Access Act of 1998, HR 1151,
Public Law 105-219, 112 Stat. 913 (1998).
\2\ 12 U.S.C. 1790d(c); 12 CFR part 702; 65 FR 8560 (Feb. 18,
2000); see 702 subpart C for categories for ``new'' credit unions.
\3\ Id. at Sec. 1790d(e), (f) and (g); 12 CFR 702 subpart B.
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The Act defines a credit union's capital level based on a net worth
ratio requirement for all credit unions and a risk-based net worth
requirement for credit unions the Board defines as

[[Page 9692]]

complex.\4\ The Act also provides the NCUA Board with broad discretion
to design the risk-based net worth requirement. However, the net worth
ratio is defined in the Act as a credit union's ratio of net worth to
total assets. The Act defines net worth as: \5\
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\4\ In 2000, NCUA adopted part 702 of NCUA Rules and Regulations
to implement the Act's system of prompt corrective action.
\5\ Id. at Sec. 1790d(o)(3); 12 CFR 702.2(g) and (k).
---------------------------------------------------------------------------

The retained earnings balance of the credit union, as
determined under generally accepted accounting principles, together
with any amounts that were previously retained earnings of any other
credit union with which the credit union is combined;
Secondary capital of a low-income designated credit union
that is uninsured and subordinate to all other claims of the credit
union, including the claims of creditors, shareholders, and the Share
Insurance Fund; and \6\
---------------------------------------------------------------------------

\6\ In 1996, the NCUA Board authorized low-income designated
credit unions, including state chartered credit unions to the extent
permitted by state law, to count as capital uninsured secondary
capital. At the time, the Board recognized that it was difficult for
low-income designated credit unions to accumulate capital only
through retained earnings. The Board, therefore, permitted low-
income designated credit unions to use the borrowing authority in
the Act to issue secondary capital accounts. This authority would
allow these credit unions to build capital to support greater
lending and financial services to their members and their
communities, and to absorb losses to protect them from failing. To
ensure the safety and soundness of secondary capital activity, the
1996 rule imposed various restrictions on its use and structure. At
this time, prompt corrective action and the associated definition of
net worth was not yet part of the Act. 61 FR 50696 (Sept. 27, 1996).
---------------------------------------------------------------------------

Certain assistance provided under section 208 of the Act
pursuant to NCUA regulations.\7\
---------------------------------------------------------------------------

\7\ 12 U.S.C. 1790d(o)(2).
---------------------------------------------------------------------------

As noted above, per the Act, secondary capital is currently only
permissible for low-income designated credit unions to issue and to be
counted toward the net worth ratio. NCUA also counts secondary capital
issued by low-income designated credit unions as net worth for the
risk-based net worth ratio.
The Board notes that, NCUA cannot change the Act's definition of
net worth--only Congress can. However, the Board has broad discretion
in designing the risk-based net worth requirement. Thus, it is possible
for the Board to authorize a credit union that is not low-income
designated to issue alternative capital instruments that would count
towards satisfying the risk-based net worth requirement--but not the
net worth ratio. (See the discussion of legal authority in Section IV).
For purposes of this ANPR, the term supplemental capital includes any
form of capital instruments credit unions that are not designated as
low-income might be authorized to issue and count only for inclusion in
the risk-based net worth requirement.
The risk-based net worth requirement for federally insured credit
unions is based on a risk-based net worth ratio calculation in Part 702
of NCUA's Rules and Regulations.\8\ Per the Board's October 2015 final
rule, on January 1, 2019, the risk-based net worth requirement will be
updated to replace the risk-based net worth ratio with a new risk-based
capital ratio.\9\
---------------------------------------------------------------------------

\8\ Unless otherwise noted, throughout this ANPR references to
prompt corrective action, risk-based capital, and citations to Part
702 refer to Part 702 as revised by the Board at its October 2015
meeting.
\9\ 80 FR 66626 (Oct. 29, 2015).
---------------------------------------------------------------------------

During the risk-based capital rulemaking process, the Board asked
for stakeholder input on supplemental capital. Specifically, in the
January 2015 risk-based capital (RBC) proposal the NCUA Board posed the
following six questions: \10\
---------------------------------------------------------------------------

\10\ 80 FR 4340, 4384 (Jan. 27, 2015).
---------------------------------------------------------------------------

1. Should additional supplemental forms of capital be included in
the RBC numerator and how would including such capital protect the
Share Insurance Fund from losses?
2. If yes, to be included in the RBC numerator, what specific
criteria should such additional forms of capital reasonably be required
to meet to be consistent with Generally Accepted Accounting Practices
(GAAP) and the Act, and why?
3. If certain forms of certificates of indebtedness were included
in the risk based capital ratio numerator, what specific criteria
should such certificates reasonably be required to meet to be
consistent with GAAP and the Act, and why?
4. In addition to amending NCUA's RBC regulations, what additional
changes to NCUA's regulations would be required to count additional
supplemental forms of capital in NCUA's RBC ratio numerator?
5. For state-chartered credit unions, what specific examples of
supplemental capital currently allowed under state law do commenters
believe should be included in the RBC ratio numerator, and why should
they be included?
6. What investor suitability, consumer protection, and disclosure
requirements should be put in place related to additional forms of
supplemental capital?
In response to these questions, a majority of the commenters who
addressed supplemental capital stated that it was imperative that the
Board consider allowing credit unions access to additional forms of
capital. The commenters suggested credit union authority to issue
supplemental capital was particularly important as credit unions are at
a disadvantage in the financial market because most lack access to
additional capital outside of retained earnings. While none of the
commenters offered specific suggestions on how to implement
supplemental capital, a few did suggest that the Board should
promulgate broad, non-prescriptive rules to allow credit unions maximum
flexibility in issuing supplemental capital.
As the Board did not receive comments with sufficient detail in
response to the RBC proposal, the Board is again posing the six
questions listed above for commenters to consider and address.
Throughout this ANPR, the Board will expand on these six questions and
ask more specific questions about the structure, form, regulations, and
requirements related to supplemental capital, as well as relevant
changes and improvements to secondary capital. The Board encourages all
stakeholders to address in detail as many of these questions as
possible and provide the Board with specific comments and responses.
The Board intends these questions to be a starting point for commenters
to present their thoughts, but invites comments on all aspects of
alternative capital
Throughout this ANPR the Board discusses several complex topics and
uses terms to refer to specific forms of capital. In addition to
supplemental, secondary, and alternative capital, the Board will use
the term ``regulatory capital'' when referring to financial instruments
issued by credit unions or banks, that include both equity and debt,
and other financial statement account which meet the criteria contained
in regulations for inclusion in the calculation of capital adequacy
measures.

II. Current Secondary Capital Standards

The Act's definition of net worth states that secondary capital
must be ``uninsured and subordinate to all other claims of the credit
union, including the claims of creditors, shareholders, and the Share
Insurance Fund.'' \11\ This means that any secondary capital issued by
a low-income designated credit union must be the most subordinated item
on the balance sheet (first loss position after retained earnings) and
any losses to secondary capital must be pro-rated equally--that is
without preference or priority. The practical effect is that low-income
designated

[[Page 9693]]

credit unions cannot include payment priority structures within or
between secondary capital instruments to enhance investors' interests.
---------------------------------------------------------------------------

\11\ 12 U.S.C. 1790d(o)(C)(ii).
---------------------------------------------------------------------------

NCUA's rules and regulations also contain various provisions
addressing the prudent and appropriate issuance and use of secondary
capital by low-income designated credit unions. These provisions are as
follows:
Low-income designed credit unions:
[cir] May only accept secondary capital accounts from non-natural
person members and non-natural person nonmembers.
[cir] Must submit and receive approval by NCUA of a Secondary
Capital Plan.
[cir] Must execute a Disclosure and Acknowledgement statement.
A secondary capital account:
[cir] Must be uninsured;
[cir] Have a minimum maturity of five years with a reduction in the
recognition of the net worth value of accounts with less than five
years of remaining maturity;
[cir] Must be subordinate to all other claims, including those of
shareholders, creditors and the Share Insurance Fund;
[cir] Must be available to cover operating losses that exceed net
available reserves and to extent losses are applied the accounts must
not be restored;
[cir] Cannot be pledged by investors as security on a loan;
[cir] Are subject to restrictions of dividends as provided in
prompt corrective action; and
[cir] May only in certain circumstances be redeemed early and only
with prior NCUA approval.\12\
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\12\ 12 CFR 701.34.
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The regulations allow NCUA to prohibit a low-income designated
credit union classified as critically undercapitalized from paying
principal, dividends, or interest on secondary capital. This provision
is to ensure secondary capital is available to cover losses while the
low-income designated credit union is operating as a going concern.
These payment restrictions are consistent with limitations on principal
and interest payments imposed by the federal banking regulators for
subordinated debt issued by banks.\13\
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\13\ 12 CFR 5.47(d)(3)(ii)(B)(3).
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Further, due to the fact that secondary capital is not a permanent
form of capital, NCUA's regulations reduce the portion of secondary
capital that is included in the net worth ratio as it approaches
maturity. Once the remaining maturity is less than five years, the
regulations require low-income designated credit unions to discount how
much a secondary capital account contributes to the credit union's net
worth value based on the following schedule: \14\
---------------------------------------------------------------------------

\14\ Id. at Sec. 701.34(c).

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

Since 2006, low-income credit unions may request NCUA approval to
redeem the portion of secondary capital no longer included in net worth
if:
The credit union will have a post-redemption net worth
classification of at least adequately capitalized;
The discounted secondary capital has been on deposit at
least two years; and
The discounted secondary capital will not be needed to
cover losses prior to the final maturity date.\15\
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\15\ Id. at Sec. 701.34(d).
---------------------------------------------------------------------------

With respect to secondary capital, the Board specifically seeks
comments on the following:
Whether or not to permit a low-income designated credit
union to sell secondary capital to non-institutional investors (see
Sections V and VI for more discussion on investor protection and
suitability issues), and whether this would be for members only or any
party.
Allowing for broader call options for the low-income
designated credit union, other than just the portion no longer counting
as net worth and subject to NCUA approval, if provided for in the
secondary capital contract.
Relaxation of pre-approval of issuing secondary capital if
a low-income designated credit union meets certain conditions such as
being at least adequately capitalized and having prior experience
issuing secondary capital.
Inclusion of more flexibility to fund dividend payments as
an operating loss if provided for in the contract.
Any other prudential restrictions on secondary capital
that should be considered.
Reorganization of the regulation to improve clarity by
moving to part 702 (Prompt Corrective Action) all matters related to
how the instrument must be structured to qualify for capital treatment.
This would move these conditions to the section of NCUA rules and
regulations applicable to all insured natural person credit unions, and
leave the provisions specific to federal credit union issuance
authority in Part 701.

III. Current and Prospective Use of Alternative Capital

This section provides information on community bank use of
subordinated debt and low-income designated credit unions' use of
secondary capital. This section also provides information on the
projected impact of risk-based capital standards on complex credit
unions to estimate the potential need for supplemental capital for
risk-based net worth requirement purposes. This information provides a
basis for estimating the potential for use of supplemental capital, the
purpose of its use, the potential purchasers, and the related costs.
The Board is interested in receiving comments concerning projections on
the volume of supplemental capital that credit unions would be likely
to issue. The Board also seeks specific comments on the structures of
supplemental capital instruments that would be beneficial, why credit
unions will issue supplemental capital, and how it fits into the credit
union's business model. The Board is also interested in any comments
about who will purchase supplemental capital. Since the costs
associated with supplemental capital are significant to the issuing
credit union, the Board seeks comments on how any regulations should
address the issue of the cost of the instrument and any items that may
be helpful in reducing the cost while maintaining adequate protection
for investors and the Share Insurance Fund.

A. Community Bank Use of Subordinated Debt

Community bank use of subordinated debt increased in 2016. As of
June, 30, 2016, the amount outstanding was $831 million compared to
$479 million as of December 31, 2016.\16\ Despite the increase,
subordinated debt is only 0.34 percent of total community bank capital.
The stated purpose of recent issuances of subordinated debt by
community banks generally fall into three categories:
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\16\ FDIC Quarterly, Volume 10, Number 2, page 18.
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Facilitate mergers and acquisitions;
Redemption of preferred stock held by the U.S. Treasury
Department due to increasing costs; and
Fund organic growth.\17\
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\17\ Based on review of a sample of SEC Form D filed by issuers.
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While the interest rate paid on community bank subordinated debt
can vary significantly, generally the interest

[[Page 9694]]

rate is from 300 to 400 basis points over ten year treasury note
rates.\18\ Additionally community banks report expenses associated with
sales commissions, ranging from 1.25 percent to 3 percent, and fees
along with legal and operational costs.\19\ Most buyers of bank
subordinated debt are reported to be pension funds, mutual funds, other
banks, and high net worth investors.\20\
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\18\ Based on review of a sample of capital market announcements
and publications of completed offerings.
\19\ Based on review of a sample of SEC Form D filed by issuers.
\20\ Based on review of a sample of capital market
announcements, publication of completed offerings, and SEC Form D.
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B. Low-Income Designated Credit Union Use of Secondary Capital

As of June 30, 2016, there were 2,426 low-income designated credit
unions. Only 73 low-income designated credit unions (about 3 percent)
report total outstanding secondary capital of $181 million.\21\ Since
December 31, 2011, the number of low-income designated credit unions
has increased by 117 percent, from 1,119 to 2,426. However, the number
of low-income designated credit unions with outstanding secondary
capital has ranged from 72 to 79 during this period.
---------------------------------------------------------------------------

\21\ NCUA Call Report data.
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The $181 million in outstanding secondary capital equates to 13
percent of the total net worth of the low-income designated credit
unions that issued it--with an average balance of about $2.5 million.
However, outstanding secondary capital is concentrated in four low-
income designated credit unions, which hold 74 percent of the total
secondary capital outstanding. When excluding these four low-income
designated credit unions, the average amount of secondary capital is
under $700,000 per low-income designated credit union. The interest
rate paid by the four largest holders of the outstanding secondary
capital ranges from 0.14 percent to 3.5 percent.
Secondary capital does, however, significantly benefit a low-income
designated credit union's net worth ratio. The secondary capital adds
an average of nearly 300 basis points to the net worth ratio, which
brings the average from just below 7 percent to near 10 percent. Out of
the 73 low-income designated credit unions with secondary capital, 66
have a net worth ratio greater than the well capitalized 7 percent
level. Without the secondary capital, 25 of the 66 would have a net
worth ratio less than 7 percent.\22\
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\22\ Secondary capital is estimated to add an average of 414
basis points to the risk-based capital ratio that will go into
effect on January 1, 2019.
---------------------------------------------------------------------------

The Board notes that low-income designated credit unions that have
issued secondary capital have a higher failure rate than other low-
income designated credit unions. The average annual failure rate for
low-income designated credit unions with secondary capital was 2.9
percent from 2000-2013, compared to 0.8 percent for low-income
designated credit unions without secondary capital during the same
period.\23\ In a few failures of low-income designated credit unions,
the assets in the credit union grew rapidly around the time the
secondary capital was issued, which in turn led to higher losses to the
Share Insurance Fund. NCUA has noted a pattern of poor practices in
some low-income designated credit unions with secondary capital that
could account for the higher failure rate, including: \24\
---------------------------------------------------------------------------

\23\ See. Secondary Capital Best Practices Guide available at
https://www.ncua.gov/services/Pages/small-credit-union-learning-center/Documents/secondary-capital-guide.pdf.
\24\ Id.
---------------------------------------------------------------------------

Poor due diligence, inaccurate cost benefit analysis and
weak strategic planning in connection with establishing and expanding
member service programs funded by secondary capital.
Concentrations of secondary capital to support unproven or
poorly performing programs.
Failure to realistically assess and timely curtail
programs not meeting expectations.
Use of secondary capital solely to delay prompt corrective
action.
Insufficient liquidity to repay secondary capital at
maturity.

C. Potential for Credit Unions' Use of Supplemental Capital

The potential use of supplemental capital is difficult to predict
due to the probable changes in market factors such as interest rates,
demographics, and competition. Since supplemental capital would only
increase a credit union's risk-based capital ratio, the most likely
users would be those credit unions with net worth ratios above the well
capitalized level but with a risk-based capital below or near the
minimum needed to be well capitalized.
The following table contains an estimate of the number of credit
unions likely to issue supplemental capital and the potential amount of
supplemental capital that might be issued. Using Call Report data as of
December 31, 2015, applied to FICUs with more than $100 million in
assets,\25\ results in the following:
---------------------------------------------------------------------------

\25\ The new risk-based net worth requirements will only apply
to credit unions with assets of $100 million or more.

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

------------------------------------------------------------------------
Number of credit unions that do not have a 140.
low-income designation with a net worth
ratio greater than 8% and an estimated risk-
based capital ratio less than 13.5%.
Net worth of the 140 credit unions that do $9.2 billion.
not have a low-income designation with a net
worth ratio greater than 8% and an estimated
risk-based capital ratio less than 13.5%.
Maximum amount of subordinated debt that $4.5 billion.
could be issued with a limit set at 50% of
net worth \26\.
Amount of supplemental capital needed by the $1.0 billion.
140 to achieve a 13.5% risk-based capital
ratio.
------------------------------------------------------------------------

The Board is interested in commenter's thoughts on whether credit
unions that are not designated as low-income use of supplemental
capital could affect the availability of secondary capital for low-
income designated credit unions. If so, are there any measures the
Board could take to protect against this?
---------------------------------------------------------------------------

\26\ The Board would contemplate some limit on how much
supplemental capital will count for risk-based capital requirements
to ensure it remains a supplemental but not the primary source of
capital. For illustration purposes the estimate uses a 50% limit so
that it would not become the primary form of capital held by these
credit unions.
---------------------------------------------------------------------------

IV. Supplemental Capital Legal Authority and Potential Taxation
Implications

A. Risk-Based Net Worth Requirement

In addition to the Act's requirements related to the net worth
ratio, the Act requires the Board to design ``a risk-based net worth
requirement for credit unions defined as complex.'' \27\ The risk-based
net worth requirement for credit unions meeting the definition of
``complex'' was first applied on the basis of data in the Call Report
as of March 31, 2001.\28\ Since its inception, the risk-based net worth
requirement has included secondary capital issued

[[Page 9695]]

by low-income designated credit unions.
---------------------------------------------------------------------------

\27\ 12 U.S.C. 1790d(d)(1).
\28\ 65 FR 44950 (July 20, 2000).
---------------------------------------------------------------------------

While the Act defined the term ``net worth,'' it did not define the
risk-based net worth requirement, nor how to calculate any
corresponding risk-based ratio. In contrast to the narrow definition of
net worth, the lack of a statutory prescription for the risk-based net
worth requirement gives the Board the latitude to include within that
requirement items that would not meet the statutory definition of ``net
worth'' but otherwise serve as capital in protecting the Share
Insurance Fund from losses when a credit union fails. Given the
statutory objective of prompt corrective action ``to resolve the
problems of insured credit unions at the least possible long-term
loss'' to the Share Insurance Fund, the Board believes it should
explore expanded options for credit unions to build capital beyond
retained earnings.
For a credit union defined as complex to be classified well
capitalized, the Act requires the credit union to have a net worth
ratio of 7 percent or greater (6 percent for adequately capitalized)
and to meet the applicable risk-based net worth requirement. Starting
in January 2019, the risk-based net worth requirement will require the
risk-based capital ratio to be 10 percent or greater to be well
capitalized (8 percent for adequately capitalized). The Act classifies
a credit union as undercapitalized if it is unable to achieve the
applicable risk-based net worth requirement, even if it has a high net
worth ratio, thus subjecting the credit union to the corresponding
prompt corrective action supervisory consequences.\29\
---------------------------------------------------------------------------

\29\ 12 U.S.C. 1790d(c)(1)(C)(ii).
---------------------------------------------------------------------------

B. Authority To Issue Supplemental Capital

The authority for low-income designated credit unions to issue
secondary capital is established in the Act. Conversely, there is no
express authority for credit unions not designated as low-income to
issue alternative forms of capital. However, the Act does provide
federal credit unions with relatively broad authority to borrow from
any source in accordance with such rules and regulations as may be
prescribed by the Board.\30\ The Board has reviewed all applicable
sections of the Act to determine the ability of federal credit unions
to issue various types of financial instruments that could serve as
alternative capital.\31\ Other than as a form of debt, there is no
other explicit authority in the Act for federal credit unions to issue
an instrument that is uninsured and could be structured as loss
absorbing capital. As a result, the Board believes only the borrowing
authority is available for federal credit unions to issue supplemental
capital.\32\ This means that federal credit unions could only issue
supplemental capital as subordinated debt. However, the Board invites
commenters to identify any other provisions of the Act they believe
could provide alternative authority for federal credit unions to issue
supplemental capital instruments other than as subordinated debt.
---------------------------------------------------------------------------

\30\ 12 U.S.C. 1757(9).
\31\ Authority to issue capital instruments for FISCUs is
determined under applicable state law.
\32\ In December 2010, the Board issued Letter to Federal Credit
Unions 10-FCU-03: Sales of Nondeposit Investments, which stated that
federal credit unions are not authorized under the Act to sell
nondeposit investments directly to their members. After further
consideration, the Board believes federal credit unions have the
authority to issue supplemental capital instruments under the
borrowing authority in the Act, even though these instruments may be
considered securities for purposes of state and federal securities
laws.
---------------------------------------------------------------------------

C. Supplemental Capital Relationship to Secondary Capital

Supplemental capital and secondary capital are similar in that, for
federal credit unions, both are uninsured accounts issued as borrowings
and subject to applicable statutory borrowing limits. Secondary
capital, however, is included in the statutory definition of net worth
and counts towards both the net worth ratio and the risk-based net
worth requirement. Supplemental capital is not included the statutory
definition of net worth and can only be considered for inclusion in the
computation of the risk-based net worth requirement.
Supplemental capital would have to be subordinate to the Share
Insurance Fund and uninsured shareholders in the payout priorities.
However, since secondary capital, per the Act, must be subordinate to
all other claims, supplemental capital would be senior to secondary
capital in the payout priorities. Credit unions issuing supplemental
capital could be provided flexibility to include payment priority
structures within or between supplemental capital instruments to
enhance investors' interests.

D. Need for Comprehensive Borrowing Rule for Federal Credit Unions

The Board is considering expanding the borrowing rule to clarify
this authority for federal credit unions. As noted above, the Act
states that federal credit unions may ``borrow, in accordance with such
rules and regulations as may be prescribed by the Board, from any
source.'' Currently, NCUA's regulations only contain a rule addressing
when federal credit unions borrow from natural persons. Given that the
wording of the Act could suggest a federal credit union's borrowing
authority is contingent on rules and regulations prescribed by the
Board, it may appear to investors that federal credit unions are
restricted to only borrowing from natural persons. While the Board
disagrees with this reading of the Act, the Board is concerned that
some supplemental capital investors may question a federal credit
union's authority to issue supplemental capital instruments to anyone
other than natural persons. Clarity and certainty about a federal
credit union's borrowing authority may be important to the sale of
supplemental capital--by expanding the potential investor base and
reducing unnecessary transaction complications. With respect to this
topic, the Board is interested in commenter's views on whether the
Board should promulgate a more comprehensive borrowing rule as part of
any authorization of supplemental capital, and what the rule should
address.

E. Authority for Federally Insured State Chartered Credit Unions To
Issue Supplemental Capital

The authority under which a federally insured state chartered
credit union could issue alternative capital instruments is distinct
from whether and to what extent NCUA, as insurer, would recognize it as
regulatory capital for prompt corrective action purposes. A federally
insured state chartered credit union's authority to issue supplemental
capital would be derived from applicable state law and regulation
regarding its ability to issue liability and equity instruments. Such
state laws may be narrower or broader than those for federal credit
unions. Recognition as regulatory capital will depend on the
characteristics of the instrument and its availability to protect the
Share Insurance Fund--which would be based on uniform criteria that
apply to all federally insured credit unions. (see section VI for more
discussion)
For federal credit unions, the Act limits the aggregate amount of
borrowed funds to 50 percent of paid-in and unimpaired capital and
surplus.\33\ Per

[[Page 9696]]

Sec. 741.2, NCUA's rules and regulations limit borrowing by federally
insured state chartered credit unions to 50 percent of paid-in and
unimpaired capital and surplus. The regulation does provide the ability
for state credit unions to obtain a waiver up to the amount of
borrowing allowed under state law.\34\ The Board is not aware of any
federally insured state chartered credit unions that have requested a
waiver to the borrowing limit in the past decade. While authority to
issue alternative capital instruments for federally insured state
chartered credit union is determined under state law, it is possible
that some states will only allow their credit unions to issue
alternative capital instruments under applicable borrowing authority.
As NCUA's borrowing limit for federally insured state chartered credit
union is not statutory, the Board can entertain removing this limit and
requests comment on this option.
---------------------------------------------------------------------------

\33\ Section 700.2 of NCUA Rules and Regulations defines Paid-in
and unimpaired capital and surplus as shares plus post-closing,
undivided earnings. This does not include regular reserves or
special reserves required by law, regulation or special agreement
between the credit union and its regulator or share insurer. 12 CFR
700.2.
\34\ 12 CFR 741.2.
---------------------------------------------------------------------------

F. Potential Taxation Implications

The Board recognizes that supplemental capital could have an impact
on the credit union tax exemption. The Act specifically exempts federal
credit unions from taxation by the United States or by any State or
local taxing authority, except real and personal property taxes.\35\
With respect to federal credit unions, the Board is aware that part of
the basis for the credit union tax exemption was that Congress
recognized most credit unions could not access the capital markets to
raise capital.\36\ If all credit unions, not just low-income designated
credit unions, have the ability to access the capital markets to meet
capital standards, it could call into question one of the bases for the
credit union tax exemption. The Board invites comments on this topic
and would like to hear from stakeholders on the possible impact a
supplemental capital rule may have on the federal credit union tax
exemption.
---------------------------------------------------------------------------

\35\ 12 U.S.C. 1768.
\36\ It is noteworthy that, in 1951, thrift institutions lost
their tax exemption. The Senate report to the Revenue Act of 1951
stated that mutual savings banks and savings and loan associations
were losing their tax exemption because they had evolved into
commercial bank competitors. In addition, thrifts had evolved from
mutual organizations to ones that operated in a similar manner to
banks. Finally, the exemption had given thrifts a competitive
advantage over taxable commercial banks and life insurance
companies.
---------------------------------------------------------------------------

Unlike federal credit unions, the Act does not exempt federally
insured state chartered credit unions from taxation. Federally insured
state chartered credit unions are exempt from federal income tax under
Sec. 501(c)(14)(A) of the Internal Revenue Code. Section 501(c)(14)(A)
of the Internal Revenue Code provides for exemption from federal income
taxes for state credit unions without capital stock organized and
operated for mutual purposes without profit. At this time, there does
not appear to be an established definition of ``capital stock'' used by
the IRS. It is possible federally insured state chartered credit unions
in some states will have broad authority to issue supplemental capital
instruments that have the characteristics of capital stock, and by
doing so could subject themselves to taxation. The Board therefore
requests comment on whether NCUA should limit the types of instruments
issued by federally insured state chartered credit unions to those that
would clearly not meet the definition of capital stock. Other options
the Board could consider, include requiring a federally insured state
chartered credit unions to provide a formal opinion from the IRS that
the supplemental capital instrument it is issuing will not be
classified as capital stock or requiring the credit union to provide
projections in advance of issuing the supplemental capital
demonstrating that it can afford to be taxed and the benefits of the
supplemental capital outweigh the cost of any taxes it might become
subject to.

G. Mutual Ownership Structure of Credit Unions

The Board also invites comments on the potential effect
supplemental capital may have on the mutual ownership structure and
governance of credit unions. The Board invites comments on how it
should structure any potential rule to avoid issues impacting the
mutuality of credit unions, and the members' rights to govern the
affairs of the institution. Specifically, the Board invites comments on
restrictions it might impose on characteristics of supplemental capital
to avoid these issues, such as: Non-voting and limits on covenants in
the investment agreement that may give investors levels of control over
the credit union.

V. Securities Law Applicability

The Board believes that both secondary and supplemental capital
would be considered securities for purposes of state and federal
securities laws. The Board invites comment on this topic and its
relationship to credit unions issuing securities as supplemental
capital.
Being subject to securities laws can impose requirements on the
issuer to register with the Securities Exchange Commission (SEC), issue
SEC mandated disclosures, and comply with the SEC's broad anti-fraud
rules. The Board, however, is aware that there are two exemptions that
would likely be available to credit unions:
Section 3(a)(5) of the Securities Act, which is available
to certain types of financial institutions, including credit unions,
for the issuance of any type of security to any type of investor; \37\
and
---------------------------------------------------------------------------

\37\ 17 CFR 240.3a5.
---------------------------------------------------------------------------

Rule 506 under Regulation D under the Securities Act,
which is available to any entity offering any type of security,
provided that purchasers of the securities are ``accredited investors''
(although sales to a limited number of investors who are not accredited
are also possible under certain circumstances).\38\
---------------------------------------------------------------------------

\38\ Id. at Sec. 230.506.
---------------------------------------------------------------------------

While these exemptions are likely to relieve credit unions of the
requirements to register with the SEC and issue SEC mandated
disclosures, there are a number of other issues that credit unions must
consider and comply with before issuing any instrument that would be
considered a security. The Board briefly addresses each of these issues
below.

A. Federal Securities Requirements

Regardless of any exemption from registration and disclosure,
credit unions issuing alternative capital must still comply with the
SEC's broad anti-fraud regulations.\39\ The Securities Exchange Act of
1934's (Exchange Act) general anti-fraud prohibitions are embodied in
Sec. 10(b), which generally prohibits the use of manipulative or
deceptive devices or contrivances that violate SEC rules in connection
with the purchase or sale of securities. Most of the litigation brought
with respect to the rules promulgated under Sec. 10(b) has been
brought under the general anti-fraud provision, Rule 10b-5, which
provides as follows:
---------------------------------------------------------------------------

\39\ See, e.g., Regulation D, Rule 501(a): ``Users of Regulation
D (Sec. Sec. 230.500 et seq.) should note the following:
(a) Regulation D relates to transactions exempted from the
registration requirements of section 5 of the Securities Act of 1933
(the Act) (15 U.S.C. 77a et seq., as amended). Such transactions are
not exempt from the anti-fraud, civil liability, or other provisions
of the federal securities laws.''
---------------------------------------------------------------------------

It shall be unlawful for any person, directly or indirectly, by the
use of any means or instrumentality of interstate commerce, or of the
mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,

[[Page 9697]]

(b) To make any untrue statement of a material fact or to omit to
state a material fact necessary in order to make the statements made,
in the light of the circumstances under which they were made, not
misleading, or
(c) To engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person, in
connection with the purchase or sale of any security.\40\
---------------------------------------------------------------------------

\40\ 17 CFR 240.10b-5.
---------------------------------------------------------------------------

The primary intent of Rule 10b-5 and, more broadly, the anti-fraud
provisions of the Securities Act of 1933 (Securities Act) and Exchange
Act, is to prevent fraud, deceit, and incorrect or misleading
statements or omissions in the offering, purchase and sale of
securities. Given that intent, clear and complete disclosure is the
critical factor in ensuring the anti-fraud provisions of the Securities
Act and Exchange Act are not breached in any offering by credit unions,
regardless of whether the offering is registered with the SEC under the
Securities Act or exempt from registration.
In the absence of SEC-mandated disclosure delivery requirements,
the practical concern for credit unions relying on either the Section
3(a)(5) or Regulation D, Rule 506 exemption is determining what type
and amount of disclosure is appropriate to meet the anti-fraud
standards. The Board is aware that the amount of disclosure varies
depending on multiple factors, including:
The nature of the potential investors (focusing on their
level of sophistication);
The nature of the security being offered (focusing on the
complexity of the instrument);
The nature of the business of the issuer and the industry
in which the issuer operates (focusing on the complexity of the
business or industry); and
Market practices (focusing on the types of disclosure
commonly provided by peer companies).
In addition, the Board is aware that for any disclosure to meet the
standards of Rule 10b-5, the disclosure must not contain any untrue
statement of a material fact and must not omit to state a material
fact, the absence of which renders any disclosure being made
misleading. Further, the disclosure must be clear, accurate and
verifiable, and should cover topics that are typically important to
investors in making an investment decision, including:
Material risks relating to the issuer and the industry in
which the issuer operates;
Material risks relating to the security being offered;
The issuer's planned uses for the proceeds of the
offering;
Regulatory matters impacting the issuer and its
operations;
Tax issues associated with the security being offered; and
How the securities are being offered and sold, including
any conditions to be met in order to complete the offering.
The Board is also aware that the Office of Comptroller of the
Currency (OCC) promulgated regulations that require supervised banks
issuing securities to register directly with the OCC and issue OCC
mandated disclosures. The OCC mandated disclosures are very similar to
those required by the SEC.\41\ The Board is considering requiring
similar registration and disclosures for credit unions issuing
alternative capital. The Board is concerned that without mandated
disclosures, credit unions may be at greater risk for anti-fraud suits,
which, if successful, would impair not only the credit union but also
the Share Insurance Fund's ability to use secondary or supplemental
capital to cover losses. Further, the Board also believes it is
important that investors in credit union alternative capital
instruments have similar protections to those provided investors in SEC
and OCC covered entities. The Board is interested in comments on the
following questions in particular:
---------------------------------------------------------------------------

\41\ 12 CFR part 16.
---------------------------------------------------------------------------

Should the Board require credit unions issuing alternative
capital to register with NCUA?
How could NCUA protect the Share Insurance Fund against
potential anti-fraud claims that could impair the alternative capital's
ability to cover losses?
Should the Board mandate disclosures all credit unions
issuing alternative capital must provide to investors? If the Board
should mandate disclosures, should it base them on the SEC's, the
OCC's, or create a unique set of disclosures for credit unions? If the
Board creates a unique set of disclosures, what should it include in
those disclosures? Should the level of disclosures vary based on the
level of the investor (institutional, accredited, natural person)?
Should the Board require credit unions to develop policies
and procedures to ensure ongoing compliance with anti-fraud
requirements before it begins issuing alternative capital?
The Board is also aware that there may be potential broker-dealer
registration issues related to secondary and supplemental capital.
Specifically, marketing activities by a credit union and its employees
could require the credit union to register as a broker-dealer. While
there are exemptions available to credit unions and their employees,
the Board notes that these exemptions are complex and require a
thorough evaluation of a credit union's practices and the activities of
its employees. If a credit union or its employees fail to qualify for
an exemption, the credit union or employee could be required to
register as a broker-dealer or face penalties for failure to comply
with applicable rules. The Board has previously stated that federal
credit unions are not permitted to register as broker-dealers.\42\ The
Board invites comments on how it should ensure a credit union has
determined if it or its employees are required to register.
---------------------------------------------------------------------------

\42\ NCUA Letter to FCUs 10-FCU-03, Sale of Nondeposit
Investments, December 2010.
---------------------------------------------------------------------------

In addition, it is unlikely that credit unions and their employees
would be subject to investment adviser registration requirements. The
Board notes that certain marketing activities and relationships with
other credit unions could raise investment adviser requirements. The
Board, therefore, invites comments on this issue and if NCUA should
require credit unions to have policies and procedures to ensure their
activities do not trigger investment adviser registration requirements.

B. State Securities Requirements

First, certain provisions of the Securities Act and SEC rules have
preempted state securities laws with respect to most covered
securities. However, states may require issuers to register with the
state and/or pay state registration fees. Further, states may also
pursue fraud-based claims. The Board invites comment on how it should
ensure that any credit union issuing alternative capital has considered
and complied with all applicable state laws.

C. Director and Officer Liability Coverage

The Board also notes that issuing securities can affect a credit
union's director and officer liability coverage. A lack of coverage
could not only impair the credit union, but also threaten the Share
Insurance Fund in the event there are losses that the credit union is
ultimately responsible for. Before engaging in supplemental or
secondary capital activities, therefore, credit unions will need to
evaluate coverage to

[[Page 9698]]

ensure these activities are covered under their policy. The Board
requests comments on if it should mandate that credit unions certify
that they have evaluated their policies and have sufficient coverage
before beginning secondary or supplemental capital activities.

D. Contractual Matters and Communications

A credit union will need to address contractual provisions between
the credit union and its investors. Often these provisions will include
requiring ongoing communications with investors, reporting of
compliance with the contractual covenants, and sharing of information
with current and prospective investors. Credit unions will have to
develop policies and procedures to comply with these covenants and
provisions and ensure that they are not providing non-public
information to investors that is not generally available to all
investors. Failure to comply with the investment contracts or to
properly monitor communications and sharing of information could
subject the credit union to liability, which could negatively impact
the Share Insurance Fund. As such, the Board requests comment on if it
should mandate comprehensive policies addressing compliance with
investment contracts, communications, and information sharing. The
Board invites commenters to provide suggestions on the specific details
that should be in the policy and if sufficient policies should be a
prerequisite to engaging in supplemental or secondary capital
activities.

VI. Other Investor Considerations

Section 701.34(b) of NCUA's regulations limits eligible investors
in secondary capital to institutional investors, referenced as non-
natural persons.\43\ This limitation is not required by the Act. This
limitation prevents the sale of secondary capital to consumers who
could lack the ability to understand the risks associated with
secondary capital, especially when there is opportunity for confusion
given that the low-income designated credit union is federally insured.
Also, low-income designated credit unions can sell secondary capital to
nonmembers. When the secondary capital regulations were written in 1996
the purchasers of secondary capital were presumed to be foundations and
other philanthropic-minded institutional investors.\44\
---------------------------------------------------------------------------

\43\ 12 CFR 701.34(b).
\44\ 61 FR 378 (Feb. 2, 1996).
---------------------------------------------------------------------------

From an investor protection standpoint, the issue of limiting the
sale of secondary capital and supplemental capital largely focuses on
providing adequate protections to the purchasers through the issuance
of initial disclosures, transparency standards with respect to
reporting of information about the operations and performance of the
credit union, and whether the purchaser has the necessary
sophistication relative to the complexity and risk of the instrument.
As discussed in more detail in the Section V, Securities Law
Applicability, of this ANPR, the OCC requires banks issuing
subordinated debt to comply with the securities offering disclosure
rules in its regulations.\45\ The OCC's regulations establish
registration statement and prospectus requirements for the offer and
sale of securities issued, subject to exemptions and disclosure
requirements based on the sophistication of the investor. As banks are
not restricted in who they can sell securities to, these rules, in
part, help provide a level of investor protection, particularly for
less sophisticated, non-institutional investors.
---------------------------------------------------------------------------

\45\ 12 CFR 5.47(d)(3)(iii).
---------------------------------------------------------------------------

The issue of permissible investors is also related to anti-fraud
considerations. As noted above, the level of disclosures necessary to
comply with anti-fraud rules varies, in part, on the level of
sophistication of the investors. In practice, selling to non-
sophisticated investors would likely involve a much higher initial and
ongoing disclosure and communications burden for credit unions.
Thus, the Board requests comment on whether the sale of secondary
and supplemental capital should be limited to only institutional
investors, include accredited investor, or allow for anyone to
purchase. If the Board were to allow credit unions to sell alternative
capital to non-accredited investors, should there be limits on the
amount individual investors can purchase? Also, should there be
conditions on how the sale to non-accredited investors must be handled
to minimize potential confusion about its lack of federal insurance?
Whether credit unions that are not low-income designated should be
able sell supplemental capital instruments to nonmembers with equity
like characteristics is a matter relevant to considerations about the
mutual model of credit unions. The Board requests comments on the
extent to which credit unions should be allowed to sell alternative
capital with equity like characteristics to nonmembers, and if so, what
controls are necessary to preserve the mutual ownership structure and
democratic governance of credit unions. The Board invites comments on
how it should structure any potential rule to avoid issues impacting
the mutuality of credit unions, and the members' rights to govern the
affairs of the institution.

VII. Prudential Standards for Issuing and Counting Alternative Capital
for Prompt Corrective Action

For a financial instrument to be considered regulatory capital for
prompt corrective action purposes, NCUA must consider the instrument's
degree of permanence, capacity to absorb losses as a going concern, the
flexibility of principal and interest payments, and intended use of the
proceeds. These characteristics are consistent with the Basel Tier 2
capital criteria.\46\ These same criteria are also contained in the
regulatory capital quality distinctions for the U.S. banking
system.\47\ Provisions related to these characteristics are intended to
ensure the funds will be available to protect the Share Insurance Fund
and do not create incentives for credit unions to engage in unsafe or
unsound practices.
---------------------------------------------------------------------------

\46\ Basel III was published in December 2010 and revised in
June 2011. The text is available at http://www.bis.org/publ/bcbs189.htm. The BCBS is a committee of banking supervisory
authorities, which was established by the central bank governors of
the G-10 countries in 1975. More information regarding the BCBS and
its membership is available at http://www.bis.org/bcbs/about.htm.
Documents issued by the BCBS are available through the Bank for
International Settlements Web site at http://www.bis.org. See
paragraph number 58 for criteria for inclusion in Tier 2 Capital.
\47\ 12 U.S.C. 324.20.
---------------------------------------------------------------------------

The function of supplemental capital is to protect the credit union
and the Share Insurance Fund in the event of loss. Supplemental
capital, therefore, must be able to absorb losses ahead of the Share
Insurance Fund while not conferring control of the credit union to the
investor. The instruments must be uninsured and cannot be guaranteed or
secured by the credit union or its assets. These features ensure
supplemental capital fulfils its ultimate purpose and does not result
in unintended encumbrances to the credit union or the Share Insurance
Fund.
The degree of permanence is important because the instrument must
create sufficient stability in the credit union's capital base to be
available to cover losses over a long time period. This is the reason
for the minimum five year maturity contained in the Basel accords, the
U.S. banking capital regulations, and for secondary capital

[[Page 9699]]

for low-income designated credit unions. With respect to secondary
capital, a low-income designated credit unions is allowed to have a
call option for the portion no longer qualifying as net worth so that
they may retire the instrument if it is no longer needed or market
conditions allow them to reprice the capital at a lower rate. However,
supervisory approval is needed before any call is exercised because it
represents a potentially material change to the risk to the Share
Insurance Fund.
The alternative capital must be able to absorb losses while the
institution is still a going concern, and not just in the case of
liquidation. The existing regulatory language regarding secondary
capital requires that it is available to ``cover operating losses.''
\48\ The term ``operating losses'' has been interpreted to not include
the payment of dividends on shares.\49\ However, a credit union's
inability to fund a dividend rate that is consistent with prevailing
rates can create liquidity and reputation risk. Therefore, credit
unions may need the flexibility to issue alternative capital
instruments that are available to absorb all losses in excess of
retained earnings, including the payment of dividends on shares.\50\
The Board is seeking comment on the exclusion of dividend expenses as
an operating expense and seeks comment on how to resolve the complexity
that can result from excluding dividend expense from losses applied to
secondary capital but not from losses applied to supplemental capital.
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\48\ 12 CFR 701.34(b)(7).
\49\ 12 CFR 701.34.
\50\ If the Board authorizes supplemental capital, it could be
possible for low income designated credit unions to concurrently
offer both supplemental and secondary capital instruments. The
differing treatment of payments on dividends could make the
administration of losses applied to alternative capital complex and
potentially confusing.
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Further, the payment of interest on the instruments must be capable
of being cancelled on a permanent, noncumulative basis without
constituting a default. The interest provisions must also not contain
any feature which would provide incentive for the credit union to
exercise a call option, such as a large increase in the interest rate.
The flexibility of payments ensures investors cannot obviate any risk
exposure to their principal through problematic dividend and interest
provisions. These criteria are consistent with the criteria for
inclusion in Tier 2 capital used by the other banking regulators \51\
and are contained in Basel III.\52\
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\51\ 12 CFR 5.47.
\52\ Basel III was published in December 2010 and revised in
June 2011. The text is available at http://www.bis.org/publ/bcbs189.htm. See paragraph 58 for criteria for inclusion in Tier 2
Capital.
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Because of these characteristics, most alternative capital
instruments can have relatively low liquidity for the purchaser and
there is no guarantee of a secondary market. These characteristics also
impact the interest rate the credit union must pay for alternative
capital. The Board seeks comment on how to maintain protection of the
Share Insurance Fund while minimizing the impact the criteria would
have on the cost and marketability of the alternative capital
instruments.

A. Approval To Issue and Notice

The Board is considering including an application and notice
requirement in any supplemental capital regulations it may issue.\53\
The Board notes that requiring a credit union to obtain approval to
issue alternative capital and provide a notice of issuance can
contribute to ensuring alternative capital instruments are issued in
accordance with applicable regulations, part of a sound management
plan, and are structured to properly protect the Share Insurance
Fund.\54\
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\53\ Secondary capital provisions already require low income
designated credit unions to obtain prior NCUA approval.
\54\ See. 12 CFR 5.47(f) and (h) for the OCC's requirements for
prior approval for issuance of subordinated debt and for the notice
procedure for inclusion as tier 2 capital.
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The Board notes that currently NCUA requires a low-income
designated credit union to submit a ``Secondary Capital Plan'' prior to
the acceptance of secondary capital that includes: \55\
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\55\ 12 CFR 701.34(b)(1).
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The maximum aggregate amount of secondary capital the low-
income designated credit union plans to accept;
The purpose for which the secondary capital will be used
and how it will be repaid;
Demonstration that the uses of the secondary capital
conform to the low-income designated credit union's strategic plan,
business plan, and budget; and
Supporting pro forma financial statements covering a
minimum of two years.
The account agreement associated with any alternative capital needs
to conform to the standards that ensure it protects the Share Insurance
Fund and provide the credit union with flexibility in conducting its
daily affairs. The secondary capital regulation currently requires that
the low-income designated credit union retain the original account
agreement and the ``Disclosure and Acknowledgment'' for the term of the
agreement.\56\ The regulation does not specifically require a low-
income designated credit union to submit to NCUA either a draft account
agreement with the application or the executed agreement.
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\56\ Id. at Sec. 701.34(b)(11).
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For all forms of alternative capital, the Board seeks comments on
the utility of a prior approval process and a post-issuance
notification process. The Board can also consider under what conditions
prior approval would not be necessary, such as credit unions that are
well capitalized with a successful history of issuing alternative
capital. When prior approval would be necessary, however, the Board
requests comments on what should be required in an application for
authority to issue alternative capital, and how long the credit union
would have to issue the alternative capital after approval. In
addition, the Board request comment on the evaluation criteria NCUA
should use to approve or deny the application, including whether or not
certain credit unions that are already in danger of failing should be
precluded from issuing alternative capital as a form of investor
protection. Also, the Board seeks comment on the manner of and what
should be included in any post-issuance notice credit unions would file
with NCUA.

B. Subordination

Secondary capital must be subordinate to all other claims per the
Act.\57\ Thus, supplemental capital must have a payout priority senior
to secondary capital but still subordinate to the Share Insurance Fund.
The requirement that alternative capital instruments are subordinate to
the Share Insurance Fund, uninsured shareholders, and general creditors
is consistent with the Basel criteria for Tier 2 capital.\58\
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\57\ 12 U.S.C. 1790d(o)(2)(C)(ii).
\58\ Basel III was published in December 2010 and revised in
June 2011. The text is available at http://www.bis.org/publ/bcbs189.htm. The BCBS is a committee of banking supervisory
authorities, which was established by the central bank governors of
the G-10 countries in 1975. More information regarding the BCBS and
its membership is available at http://www.bis.org/bcbs/about.htm.
Documents issued by the BCBS are available through the Bank for
International Settlements Web site at http://www.bis.org. See
paragraph number 58 for criteria for inclusion in Tier 2 Capital.
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Unlike secondary capital, supplemental capital is not subject to
provisions in the Act that limit flexibility in structuring payment
priorities within and between supplemental capital instruments. For
example, a credit union could issue a supplemental capital instrument
with

[[Page 9700]]

two tranches, a high-yield-high-risk supporting tranche and a lower-
yielding-lower risk tranche. Credit unions could also issue
supplemental capital instruments that have first in-first out, or last
in-first out contractual payment priorities. This flexibility could
help credit unions attract investors of different risk tolerances and
profiles. The Board seeks comment on whether authorizing supplemental
capital regulations should contain any restrictions on payment priority
options, and if so, what should they be.

C. Limit on Amount of Supplemental Capital That Counts as Regulatory
Capital

While supplemental capital can protect the Share Insurance Fund and
uninsured shares from losses, reliance on alternative capital as the
primary source of capital is generally unsafe and unsound. Even with a
high level of permanent capital, such as retained earnings and common
stock, heavy reliance on alternative capital can result in wide
fluctuations in capital measures due to the timing of its maturity and
negative impact on earnings due to the associated costs.
U.S. bank capital regulations require banks to hold minimum levels
of common equity tier 1 capital, total tier 1 capital, and total tier 1
and tier 2 capital to total risk assets that ensures that permanent
capital is generally the primary source of regulatory capital.\59\ An
FDIC-supervised institution must maintain the following minimum capital
ratios: \60\
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\59\ 12 CFR 324.10(a).
\60\ The standardized capital ratio calculations are defined in
12 CFR 3.10(b). The Common Equity Tier 1 Capital Ratio is the ratio
of Common Equity Tier 1 Capital to standardized total risk-weighted
assets. The Tier 1 Capital Ratio is the ratio of Tier 1 Capital to
standardized total risk-weighted assets. The Total Capital Ratio is
the ratio of total capital (Tier 1 Capital plus Tier 2 Capital) to
standardized total risk-weighted assets. The Leverage Ratio is
generally Tier 1 Capital to total consolidated assets. The
components of regulatory capital are defined in 12 CFR 3.20. Common
Equity Tier 1 Capital is generally common stock, retained earnings,
and accumulated other comprehensive income. Additional Tier 1
Capital primarily includes noncumulative perpetual preferred stock.
Tier 2 Capital generally includes limited allowance for loan and
lease losses, certain subordinated debt and preferred stock, and
qualifying capital minority interests.
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A common equity tier 1 capital ratio of 4.5 percent;
A tier 1 capital ratio of 6 percent;
A total capital ratio of 8 percent; and
A leverage ratio of 4 percent.\61\
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\61\ Id. at Sec. 324.10(a).
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Additionally to be classified as well capitalized a bank must have:
A total risk-based capital ratio of 10.0 percent or
greater;
A Tier 1 risk-based capital ratio of 8.0 percent or
greater;
A common equity tier 1 capital ratio of 6.5 percent or
greater; and
A leverage ratio of 5.0 percent or greater.\62\
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\62\ Id. at Sec. 324.403(b)(1).
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As a result, banks are inherently limited in how much Tier 2 forms
of capital will be included in meeting their regulatory capital
standards. Most forms of alternative capital likely available to credit
unions will be in the form of subordinated debt--which does not meet
the standards to qualify as Tier 1 capital.
Neither the Act nor NCUA regulations limit the amount of secondary
capital that can make up a low income designated credit union's net
worth. Given their unique needs and mission, low-income designated
credit unions can primarily rely on secondary capital to meet prompt
corrective action requirements, provided their use of the proceeds and
overall ongoing management of their secondary capital is otherwise safe
and sound. However, the Board believes any regulation for supplemental
capital needs to contain some method of preventing supplemental
capital, a lower quality of capital, from becoming the primary
component of regulatory capital for credit unions. The Board seeks
comments on how capital regulations could be designed to limit the
amount of supplemental capital included in regulatory capital
calculations.
Consistent with Basel, U.S. bank capital standards,\63\ and
secondary capital regulations, the portion of supplemental capital that
would be considered as regulatory capital and included in the
calculation of the risk-based net worth requirement would be subject to
reductions during the last five years of the life of the instrument.
Consistent with secondary capital, at the beginning of the each of last
five years of the life of the supplemental capital, the amount that is
eligible to be included in the risk-based net worth requirement would
be reduced by 20 percent of the original amount of the instrument (less
any redemptions that may have occurred). The Board seeks comments on
this concept and how to reflect the increasingly limited utility as
loss absorbing capital for supplemental capital approaching maturity.
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\63\ 12 CFR 324.20(d)(iv).
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The Board also notes that changing conditions and circumstances may
warrant early repayment of alternative capital, in part or in whole.
The decision on early repayment must reside with the issuing credit
union and not the holder of the instrument, to ensure the permanence of
the instrument and prevent undue influence by investors. Currently the
secondary capital regulations only allow for early redemption of the
amount of secondary capital that is not recognized as net worth, with
approval by NCUA.\64\
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\64\ 12 CFR 701.34(d).
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Regulatory controls over early repayment are necessary to protect
the Share Insurance Fund and uninsured shares. Regulatory controls over
early repayment are also consistent with the Basel framework for
subordinated debt and the other banking agencies' regulations, which
provide control over the early repayment of subordinated debt by:
Requiring all banks to obtain prior approval to prepay or
call subordinated debt included in tier 2 capital.\65\
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\65\ Id. at Sec. 5.47(d)(1)(vii).
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Prohibiting the holder of subordinated debt from having a
contractual right to accelerate principal or interest payments in the
instrument, except in the event of a receivership, insolvency,
liquidation, or other similar proceeding.\66\
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\66\ Id. at Sec. 5.47(d)(2).
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Prohibiting the exercise of a call option in the first
five years following issuance, except in certain very limited
circumstances.
Enabling regulations for supplemental capital will need to address
the issue of prepayment and call provisions for supplemental capital.
The options regarding the abilities of a credit union to prepay
supplemental capital could include minimum capital measures after
repayment, current and expected future performance measures and notice
criteria of varying degrees. The Board invites comments on the topic of
prepayment and call provisions for alternative capital and how it
should structure any related requirements. Allowing credit unions
greater flexibility to eliminate the cost of alternative capital or
reprice the instrument under better terms could provide benefits to the
credit union. Any alternative to the redemption process would be
contingent on the credit union no longer relying on the alternative
capital to achieve an appropriate level of capital.

D. Reciprocal Holdings

Regulations for alternative capital need to address reciprocal
holdings. Reciprocal holdings exist when two or more credit unions hold
each other's alternative capital. Reciprocal holdings

[[Page 9701]]

of alternative capital, without some form of adjustment, would
artificially inflate the level of capital in the credit union system,
create loss transmission channels between credit unions, and could be
subject to abuse.
The Board notes a national bank or federal savings association must
deduct investments in the capital of other financial institutions it
holds reciprocally, where such reciprocal cross holdings result from a
formal or informal arrangement to swap, exchange, or otherwise intent
to hold each other's capital instruments, by applying the corresponding
deduction approach.\67\ The Board requests comment on how NCUA should
address this concern.
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\67\ 12 CFR 3.22(c)(3).
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E. Merger

Per the current regulation, in the event of merger of a low-income
designated credit union (other than merger into another low-income
designated credit union) the secondary capital accounts will be closed
and paid out to the investor to the extent they are not needed to cover
losses at the time of merger or dissolution. The OCC prohibits a
covenant or provision in subordinated debt instruments that requires
the prior approval of a purchaser or holder of the subordinated debt
note in the case of a voluntary merger where the resulting institution
assumes the due and punctual performance of all conditions of the
subordinated debt note and where the agreement is not in default of the
various other covenants.\68\
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\68\ 12 CFR 5.47(d)(2)(iv).
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In order to avoid any perceptions of an alternative capital holder
having ownership rights, any restrictions on merger or other change of
control must not interfere with the credit union's ability to exercise
its business judgement and management of the credit union in a manner
that avoids unsafe and unsound practices. The Board seeks comment on
the issue of merging credit unions and how alternative capital should
be treated post-merger.

F. Other Restrictions

Supplemental capital must not contain contractual terms that would
limit or impede the authority of NCUA or a State Supervisory Authority
to undertake supervisory action, as necessary, to protect the issuing
credit union's members or the Share Insurance Fund. Any such
contractual terms would impose unsafe and unsound limits on the credit
union's and regulators' ability to manage the institution and address
problems. Affirmative covenants within the supplemental capital note or
agreement must not restrict operations or potentially require a credit
union to violate a law or regulation. Negative covenants should not
unreasonably impair the credit union's flexibility in conducting its
operations or interfere with management. Without these restrictions,
contractual terms could undermine the purpose of supplemental capital
and provide holders of these obligations with unintended rights and
control over the credit union's operations. Any representation or
warranties contained in the agreements that would require acceleration
and repayment of the subordinated debt note because of a technical
violation that does not reflect underlying credit issues could be
contrary to safety and soundness. The Board seeks comments on the issue
of contractual restrictions for alternative capital instruments.

VIII. Supporting Regulatory Changes

A. 701.32--Payment on Shares by Public Unit Nonmembers

Due to the potential use of alternative capital as a funding source
similar to public units and nonmembers, the NCUA Board is seeking
comment on Sec. 701.32 of NCUA's regulations as it prescribes limits
placed on these accounts.
Section 1757(6) of the FCU Act grants federal credit unions the
power ``to receive from its members, from other credit unions, from an
officer, employee, or agent of those nonmember units of Federal, Indian
tribal, State, or local governments and political subdivisions thereof
enumerated in section 1787 of this title and in the manner so
prescribed, from the Central Liquidity Facility, and from nonmembers in
the case of credit unions serving predominately low-income members (as
defined by the Board) payments, representing equity, on--(A) shares
which may be issued at varying dividend rates; (B) share certificates
which may be issued at varying dividend rates and maturities; and (C)
share draft accounts authorized under section 1785(f) of this title;
subject to such terms, rates, and conditions as may be established by
the board of directors, within limitations prescribed by the Board.''
\69\
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\69\ 12 U.S.C. 1785(f).
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Currently the regulation limits total public unit and nonmember
shares to 20 percent of the total shares of the federal credit union or
$3 million, whichever is greater.\70\ Federal credit unions seeking to
exceed the limit must:
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\70\ 12 CFR 701.32(b)(1).
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Adopt a specific written plan concerning the intended use
of these shares and provide it to the Regional Director before
accepting the funds; and
Submit a written request to the Regional Director for a
new maximum level of public unit and nonmember shares.\71\
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\71\ Id. at Sec. 701.32(b)(2).
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Under Sec. 741.204, federally insured state chartered credit
unions must adhere to the requirements of Sec. 701.32 regarding public
unit and nonmember accounts.\72\ This regulation also addresses a
federally insured state chartered credit union obtaining a low-income
designation, as provided under state law, in order to accept nonmember
accounts other than from public units or other credit unions.\73\
Additionally this section addressed the ability of a federally insured
state chartered credit union to receive and redeem secondary capital
consistent with Sec. 701.34 and consistent with applicable state law
and regulation.\74\
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\72\ Id. at Sec. 741.204(a).
\73\ Id. at Sec. 741.204(b).
\74\ Id. at Sec. 741.204(c) and (d).
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Because the limitations the NCUA board may prescribe to these
accounts is not statutory, the NCUA Board is interested in comments on
revisions to this regulation which would reduce the regulatory burden
of the waiver process but still provide for adequate protection of the
Share Insurance Fund.

B. 701.34--Designation of Low-Income Status; Acceptance of Secondary
Capital Accounts by LICUs

Section 701.34 of NCUA's Rules and Regulations sets out the
requirements and process for a credit union to receive a low-income
designation, the criteria for accepting secondary capital and the
inclusion of secondary capital as regulatory capital. NCUA is seeking
comment on whether the criteria and process for obtaining the low
income designation, the criteria for issuing secondary capital, and the
criteria for inclusion of secondary capital as regulatory capital
should be in separate regulations.
Section 701.34 could be solely focused on the process to receive a
low-income designation. A new section of 701 could be used to address:
The authority and requirements of secondary capital;
Grandfathering treatment of existing secondary capital in
the event of regulatory changes;

[[Page 9702]]

Requirement to comply with all applicable federal and
state laws in the issuance of secondary capital;
Requirements for written contract agreements covering the
terms and conditions of the secondary capital;
Requirements for disclosures and acknowledgement;
Investor suitability; and
Prohibitions.
The items specific to secondary capital's and supplemental
capital's inclusion in regulatory capital and related capital adequacy
issues could be consolidated into Section 702--Capital Adequacy,
including:
Standards for alternative capital instruments to be
counted as regulatory capital;
Any limits on the amount of alternative capital counted as
regulatory capital;
The role of supplemental capital in approval of a net
worth restoration plan;
Provisions for discounting regulatory capital treatments
such as violations of applicable laws or regulation, including any
deficiency cure alternatives; and
Risk weight for an investment in supplemental capital.

C. Payout Priorities

To conform the regulatory payout priorities for supplemental
capital, the payout priorities for an involuntary liquidation will need
to be revised.\75\ Supplemental capital would be listed in the payout
priority after uninsured shareholders and the Share Insurance Fund.
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\75\ 12 CFR 709.5.
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D. Other Regulations

The Board seeks comments on any other related changes to existing
regulations, such as:
Modifying the definition of insured shares in 741.4(b) to
exclude any equity shares allowed under state law, if they are in fact
uninsured;
Modifying 741.9 to provide for the existence of uninsured
accounts issued under state law by FISCUs; and
Any cohering changes to part 745 as necessary.

By the National Credit Union Administration Board on January 19,
2017.
Gerard Poliquin,
Secretary of the Board.
[FR Doc. 2017-01713 Filed 2-7-17; 8:45 am]
BILLING CODE P