Regulation D is a safe harbor from the registration requirements under the federal Securities Act of 1933.  And since 1996, federal law has made it clear that private placements under Rule 506 of Regulation D are also exempt from regulation under state blue sky laws.  By complying with the relatively simple requirements of Rule 506, an issuer may sell securities to up to 35 non-accredited investors and an unlimited number of accredited investors.  Corporations, limited partnerships and other entities, as well as trusts and natural persons, may qualify as accredited investors.  Before the change effected by the financial reform bill, the definition of “accredited investor” applicable to a natural person required that he or she:

• has, at the time of purchase, net worth, either alone or jointly with his or her spouse, of more than $1,000,000, or

• had, in each of the two most recent years, income of more than $200,000 alone or more than $300,000 jointly with his or her spouse, and a reasonable expectation of reaching the same income level in the current year.

The accredited investor test is considered by the SEC as a way to determine if a person is likely to have the ability to bear the economic risk from an investment in a private investment vehicle.  The definition of a natural person “accredited investor” had been unchanged since its adoption by the Securities and Exchange Commission in 1982.  Since then, rising home values and higher salary levels caused a significant increase in the number of individuals qualifying as accredited investors.

Three provisions of the financial reform bill, set forth in section 413, have significant consequences for the accredited investor test for natural persons:

• The SEC is directed to adjust the standard for determining the net worth of a natural person by excluding the value of the person’s primary residence.
• The SEC may review the accredited investor definition as it applies to natural persons to determine if any adjustments are appropriate “for the protection of investors, in the public interest, and in light of the economy.”  No adjustment to the net worth test would be made, however, for four years, other than the exclusion of primary residence value. 

• The SEC is directed to review the entire accredited investor definition, as it applies to natural persons, not earlier than four years after enactment and at least once every four years thereafter.  In these reviews, the SEC would apply the same criteria, namely, to consider whether changes are appropriate “for the protection of investors, in the public interest, and in light of the economy.”

Because section 413 directs the SEC to revise the natural person accredited investor definition, we expect that the SEC will act quickly to comply with the statue. The exclusion of the value of a primary residence from the net worth test will reduce the number of natural persons eligible to invest in private placements as accredited investors. It is unclear at this time what the SEC’s intention will be in any review of the accredited investor definition.

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In addition to the change in the accredited investor test, the financial reform bill, in section 926, requires the SEC to issue rules for the disqualification of Rule 506 offerings by companies involving individuals who are subject to “bad boy” orders barring them from certain financial or securities activities or who have been “convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the [SEC].”  These new rules are required to be issued within one year of enactment of the bill and are to be substantially similar to the disqualification provisions under Rule 262 of Regulation A.  It is unclear what level of involvement by these “bad actors” will disqualify an offering; clarification of this question will await the final SEC rules.

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We will provide updates on significant future developments in these areas.

CONTACT:

Timothy I. Kahler
212.704.6169

Thomas M. Rose
757.687.7715

The Regulatory Agencies state that incentive compensation arrangements at a banking organization should generally:

• Provide employees incentives that appropriately balance risk and reward;
• Be compatible with effective controls and risk-management; and
• Be supported by strong corporate governance, including active and effective oversight of incentive compensation arrangements by the Board of Directors.

The final guidance states that, because of the size and complexity of their operations, large banking organizations should have and adhere to systematic and formalized policies, procedures, and processes to govern incentive compensation arrangements.  Smaller banking organizations are expected to employ less extensive and less formalized policies, procedures and systems than their larger counterparts.

To implement the recommendations contained in the final guidance, the Regulatory Agencies will analyze incentive compensation practices at large, complex banking organizations, building on similar reviews of incentive compensation practices at large banking organizations that have been conducted by the Federal Reserve over the past year. The Regulatory Agencies will also integrate the final guidance into the regulatory examination process of smaller banking organizations.  During examinations, the Regulatory Agencies will review incentive compensation arrangements at smaller banking organizations for consistency with the safety and soundness of the banking organization while evaluating those organizations’ risk-management, internal controls and corporate governance.

Impact on Smaller Banking Organizations and Community Banks. The Regulatory Agencies will tailor the evaluation of incentive compensation arrangements implemented by smaller banking organizations, and whether these arrangements appropriately account for risk to the banking organization, to the organization’s size, complexity, business lines and risk tolerance. Smaller banking organizations and community banks should be particularly aware of the following portions of the final guidance:

• During examinations, the Regulatory Agencies will evaluate whether the banking organization has incorporated the recommendations contained in the final guidance into its incentive compensation practices.
• Banking organizations should develop risk-management processes and internal controls to support the development and maintenance of balanced incentive compensation arrangements.
• Risk-management personnel should be involved in designing incentive compensation arrangements and assessing the arrangements’ effectiveness in restraining imprudent risk taking.
• Banking organizations should continuously monitor incentive compensation arrangements, particularly incentive compensation awards and actual risk outcomes, to determine whether these awards appropriately reflect the associated risk to the organization.
• The board of directors should actively oversee incentive compensation arrangements, evaluate whether these arrangements jeopardize the banking organization’s safety and soundness and regularly review the design and function of incentive compensation arrangements.
• Directors of banking organizations should possess or have access to expertise in risk-management and incentive compensation practices in the financial services industry that is appropriate in light of the risks faced by the banking organization.
• A banking organization’s federal supervisor may initiate enforcement action if the organization’s incentive compensation arrangements (or related risk- management, control or governance processes) pose a risk to the safety and soundness of the organization.

If you have any questions regarding these matters, please contact the lawyers listed above or your regular Troutman Sanders contact.

The foregoing is only a summary of one of the many significant issues affecting bank holding companies and banking organizations. If you have any questions about the foregoing or about other financial institution issues, please direct them to your regular contact at Troutman Sanders LLP or to any of the persons listed in the sidebar to this release.

CONTACT:

Jake Lutz
Practice Group Leader
804.697.1490

Tom Powell
404.885.3294

Jerome Walker
212.704.6286

CONTRIBUTOR

Seth Winter
804.697.2329

The government task force – comprised of federal, state and local law enforcement authorities – is designed to crack down on financial crimes and securities fraud. These potential investigations could result in administrative actions, civil litigation and criminal claims against banks and holding companies, as well as their directors and officers. 

In response to this development and requests from existing clients, the Troutman Sanders Financial Crimes and Securities Fraud Team was created by combining the talents of 18 attorneys in Virginia, New York, Washington, D.C., Georgia, North Carolina, Illinois and California.

“For banks, holding companies and other financial service providers, the stakes just got higher,” said Robert W. Webb Jr., chairman and managing partner of Troutman Sanders. “But our Financial Crimes and Securities Fraud Team is available to advise and defend them with respect to financial disclosure procedures, government investigations and criminal prosecutions.”

The law firm’s multi-disciplinary group of attorneys has significant expertise in bank structuring and regulatory matters, Securities and Exchange Commission (SEC) enforcement actions, financial crimes investigations and defense of financial crimes prosecutions. The team has extensive experience handling matters wherever brought, including the Eastern District of Virginia.

The Eastern District of Virginia is home to the new government task force, as well as to the SEC’s EDGAR database and numerous facilities operated by the Federal Deposit Insurance Corp.. This will provide the task force with jurisdiction over potential defendants.

“Banks and their holding companies should immediately begin taking proactive measures to prepare for a more critical level of review in connection with financial disclosures,” said Webb.

About Troutman Sanders:
Troutman Sanders LLP is an international law firm with over 650 lawyers and 16 offices in North America, Europe and Asia. Founded in 1897, the firm’s lawyers provide counsel and advice in practically every aspect of civil and commercial law related to the firm’s core practice areas: Corporate, Finance, Litigation, Public Law and Real Estate. Firm clients range from multinational corporations to individual entrepreneurs, federal and state agencies to foreign governments, and non-profit organizations to businesses representing nearly every sector and industry. See www.troutmansanders.com for more information.

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Banks and their holding companies should take proactive measures to prepare for a more critical level of review in connection with financial disclosures. Such proactive measures include involving the bank’s outside banking and securities counsel to assess current financial reporting procedures and make recommendations for improvement, the bank’s outside accountants, and third-party loan review experts. In addition, engagement by management and the board of directors is essential to show active and responsible supervision of financial reporting responsibilities. 

Investigations are being conducted by federal bank regulatory agencies, the OCC, the Department of Justice, SIGTARP (Special Inspector General for TARP), the SEC, the Commodities Future Trading Commission, and, now, this new task force. These potential investigations may result in administrative actions, civil litigation, and criminal claims against banks, holding companies, and their directors and officers.

Troutman Sanders’ Banking and Financial Crimes Team is a multi-disciplinary group of attorneys with significant expertise in bank structuring and regulatory matters, SEC enforcement actions, and financial crimes investigations and defense of financial crimes prosecutions. The Team advises and defends officers and directors, bank holding companies, banks, and other financial services providers with respect to financial disclosure procedures and related government investigations and criminal prosecutions. In connection with the last bank failure crisis, the Team’s partners litigated with great success numerous cases against the FDIC and FSLIC throughout the United States, and have extensive experience litigating in the Eastern District of Virginia.

Under the Proposal, a community bank would need approval from its primary federal regulator before it could participate in the SBLF.  Once it obtains regulatory approval, the community bank would be eligible to receive capital investment either (1) up to 5% of its risk-weighted assets, if the bank has less than $1 billion in assets, or (2) up to 3% of its risk-weighted assets, if the bank has between $1 billion and $10 billion in assets.  Community banks that participated in the Capital Purchase Program (CPP) would be eligible to convert their CPP capital to SBLF capital.

Capital investments made through the SBLF as proposed would incentivize small business lending through lower dividend rates and no TARP restrictions.  Community banks could decrease the dividend rate they pay on SBLF capital by increasing small business lending over a baseline set using 2009 lending data.  According to the Proposal, SBLF capital would carry an initial dividend rate of 5%, which would decrease by 1% for every 2.5% increase in “incremental business lending” achieved by the community bank over a two year period.  The minimum dividend rate on SBLF capital would be 1%.  However, after five years the dividend rate on SBLF capital would increase to encourage “timely repayment.”  Importantly, the SBLF as proposed would not involve any TARP restrictions such as restrictions on executive compensation.

The Proposal, which would require approval by Congress, has drawn open support from some Democratic Congressmen, Senators on both sides of the aisle have voiced criticisms ranging from concerns regarding the cost of the SBLF to calls for the President to create the SBLF under the TARP program to more expeditiously provide capital to community banks.  No specific terms or conditions of the SBLF will be available until the Proposal is enacted by Congress and implemented by the Obama Administration.

We will monitor the Proposal’s progress through Congress.  The Administration has published a fact sheet discussing the SBLF, which may be found at http://www.whitehouse.gov/sites/default/files/FACT-SHEET-Small-Business-Lending-Fund.pdf.

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The foregoing is only a summary of one of the many significant issues affecting financial institutions.  If you have any questions about the foregoing or about other financial institution issues, please direct them to your regular contact at Troutman Sanders LLP or to any of the persons listed in the sidebar to this release.

CONTACTS

Jake Lutz
Practice Group Leader
804.697.1490

Tom Powell
404.885.3294

Jerome Walker
212.704.6286

CONTRIBUTOR

Seth Winter
804.697.2329

If the FDIC proceeds as outlined in the Proposal, the FDIC would regulate employee compensation by adjusting deposit insurance rates.  As proposed, the FDIC’s regulation would be in addition to the Federal Reserve’s incentive compensation guidelines, which were announced in October 2009.  The Federal Reserve’s guidelines propose that the Federal Reserve regulate incentive compensation and associated risk through the Federal Reserve’s examination process of bank holding companies and Fed member banks.

The Proposal sets forth the FDIC’s intent to identify criteria describing compensation structure and incorporate these criteria into the risk-based assessment structure.  Specifically, the Proposal sets forth three express goals: (1) adjusting the FDIC’s risk-based assessment rates to adequately compensate for risks presented by certain employee compensation programs; (2) using the FDIC’s risk-based assessment rates to provide incentives for insured institutions to adopt employee compensation programs that align employees’ incentives with those of other stakeholders; and (3) promoting the use of compensation programs that reward employee focus on risk management.

The Proposal also highlights certain compensation program elements that may be included in compensation programs that meet the FDIC’s goals, including: (1) employees whose activities present significant risk to the insured institution should be compensated largely in restricted, nondiscounted stock; (2) large stock awards should vest over a multi-year period and be subject to a look-back or claw-back mechanism if risky behavior ultimately leads to losses; and (3) the insured institution’s independent directors should administer the compensation program, with input from independent compensation consultants.

Certain industry groups have expressed concerns that the Proposal could signal the FDIC’s intent to regulate financial institution compensation practices and use FDIC premium payments as its enforcement mechanism.  Other industry professionals worry that the Proposal shows the FDIC approaching a slippery slope toward micromanaging financial institutions through the deposit insurance structure.

The FDIC seeks comment by February 18, 2010 on all aspects of the Proposal, including the FDIC’s stated goals and the features of compensation programs that could meet its goals.  The Proposal, including alternatives for the submission of comments, may be found at http://www.fdic.gov/news/board/2010Jan12ANPR.pdf.

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The foregoing is only a summary of one of the many significant issues affecting financial institutions.  If you have any questions about the foregoing or about other financial institution issues, please direct them to your regular contact at Troutman Sanders LLP or to any of the persons listed in the sidebar to this release.

CONTACTS

Jake Lutz
Practice Group Leader
804.697.1490

Tom Powell
404.885.3294

Jerome Walker
212.704.6286

CONTRIBUTOR

Seth Winter
804.697.2329

NAAG’s impetus for organizing the Task Force is both a reaction to the perils of the mortgage industry in 2009 and a pro-active attempt to address foreseeable issues relating to adjustable rate mortgages (“ARMs”). This year it is anticipated that the interest rate on many notes secured by ARMs will be adjusted and increased.  As a result, it is highly likely that a number of homeowners with ARMs will be unable to make their monthly mortgage payment.

Certain state regulators are concerned that these ARMs were sold to consumers who should not have been approved for a loan in the first instance and these sales have been described by certain Attorneys General as violative of their respective state consumer protection laws to the point that one or more of the Attorneys General have characterized such alleged actions as quasi “criminal”. At least one Attorney General has already hired outside counsel to consider filing an action against lenders who made ARMs.

The United States Supreme Court’s recent decision in Cuomo v Clearing House Ass’n, 129 S. Ct. 2710 (2009), has opened doors to the Attorneys General to enforce against national banks many state laws regulating the mortgage industry and promoting customer rights because certain of these regulations are now considered to be preempted by federal law.

Based on litigation emanating from Massachusetts,1 the Attorney General was allowed to enforce that state’s Unfair or Deceptive Acts or Practice (UDAP) statute, notwithstanding a consent decree with the FDIC covering the bank’s origination practices. The focus of the Massachusetts Attorney General, and we anticipate the focus of other Attorneys General, will be on loans with the following characteristics:

1. an adjustable rate mortgage with an introductory rate period of three years or less;
2. an introductory/teaser rate for the initial period that is 3 percent below the fully indexed rate;
3. the borrower’s debt-to-income ratio exceeded 50 percent when measured by the fully indexed rate (rather than the introductory/teaser rate); and
4. the loan-to-value ratio was 100 percent or the loan carried a substantial prepayment penalty or a prepayment penalty that extended beyond the introductory period.

In light of NAAG’s creation of its Task Force and the recent holding in Cuomo, mortgage lenders should now anticipate investigations and/or actions by numerous states based on allegedly unlawful conduct and the impact of such mortgage practices on housing markets.  Troutman Sanders represents mortgage leaders involving these matters and is following these developments as they unfold.

1. Commonwealth v. Fremont Investment & Loan, SJC 10258, slip op. (Mass. 2008).

CONTACTS

Ashley L. Taylor, Jr.
804.697.1286

Jake Lutz
804.697.1490

Anthony F. Troy
804.697.1318

Paige S. Fitzgerald
804.697.1404

The guidelines recognize that financial institutions often face significant challenges associated with nonperforming commercial real estate loans, and that workouts are often in the best interest of the financial institution and the borrowers.  The following guidelines demonstrate that the FDIC and other federal bank regulatory agencies will view prudent commercial real estate loan workout programs favorably.

• Performing commercial real estate loans made to creditworthy borrowers, including loans that have been renewed or restructured on “reasonable” modified terms, will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount less than the loan balance.

• Commercial real estate loans to sound borrowers that are renewed or restructured in accordance with prudent lending standards should not be adversely classified or criticized unless well-defined weaknesses exist that jeopardize repayment.

The guidelines also state that financial institutions should maintain risk management practices for workout programs that are appropriate in light of the complexity and nature of the institution’s lending activity and are consistent with sound lending practices.

The new guidelines replace the Interagency Policy Statements on the Review and Classification of Commercial Real Estate Loans, originally released in November 1991, and Review and Classification of Commercial Real Estate Loans, originally released in June 1993.  The new guidelines may be found here. The Financial Institutions Practice Group at Troutman Sanders will continue to monitor developments regarding the FDIC’s commercial real estate loan workout guidelines.

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The foregoing is only a summary of one of the many significant issues affecting bank holding companies and other financial institutions.  If you have any questions about the foregoing or about other financial institution issues, please direct them to your regular contact at Troutman Sanders LLP or to any of the persons listed in the sidebar to this release.

The Federal Reserve’s guidelines contain two separate supervisory proposals. First, the Federal Reserve would review the compensation policies and practices of 28 large, complex banking organizations to determine whether these policies and practices meet the guidelines’ principles for risk-appropriate incentive compensation. Second, the Federal Reserve would review compensation practices at regional, community and other banking organizations as part of the regular, risk-focused examination process of these banking organizations. The proposed compensation reviews would focus on the compensation of senior executives and other control persons, and individual employees and groups of employees who may expose the banking organization to significant levels of risk.

During the proposed compensation reviews, the Federal Reserve would evaluate each banking organization’s compensation practices in light of the following principles of sound incentive compensation systems: (1) incentive compensation arrangements should balance risk and financial results in a way that does not provide incentives for excessive risk-taking; (2) a banking organization’s risk-management process should reinforce and support balanced incentive compensation arrangements; and (3) banking organizations should have strong corporate governance to promote sound compensation practices.

The Federal Reserve will accept comments on its proposed guidelines for 30 days. The proposed guidelines may be found here. The Financial Institutions Practice Group at Troutman Sanders will continue to monitor developments regarding the Federal Reserve’s proposed compensation guidelines.

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The foregoing is only a summary of one of the many significant issues affecting bank holding companies and other financial institutions. If you have any questions about the foregoing or about other financial institution issues, please direct them to your regular contact at Troutman Sanders LLP or to any of the persons listed in the sidebar to this release.

Under the new capital program, the Treasury would make lower-cost capital available to community banks with assets under $1 billion that submit a plan to increase small business lending. Though the Treasury has not yet released the specific program terms, this program would function similarly to the TARP Capital Purchase Program (CPP). The program’s lower-cost capital would carry an initial dividend rate of 3%, compared to an initial dividend rate of 5% for the Treasury’s CPP investments. Eligible community banks may receive capital under this program totaling up to 2% of risk-weighted assets.

President Obama instructed the Treasury to determine how the Treasury will handle existing CPP participants that wish to refinance CPP capital with lower-cost capital under the new capital program. Community Development Financial Institutions (CDFIs) may also participate in the new capital program, which will offer lower-cost capital to CDFIs at an initial dividend rate of 2%.

The President also announced his support for legislative efforts to increase the maximum size of certain SBA loans. Under this proposal, the maximum loan size for the largest SBA loan program, the 7(a)program, would increase from $2 million to $5 million and the maximum loan size for 504 loans would increase from $2 million to $5 million supporting a total project of $12.5 million (or from $4 million to $5.5 million for manufacturers supporting a total project of $13.75 million). Additionally, the maximum loan size for the SBA’s microloan program would increase from $35,000 to $50,000.

The Financial Institutions Practice Group at Troutman Sanders will continue to monitor developments regarding the new 3% capital program and the SBA proposals. It remains to be seen whether or not these measures will significantly impact community banks or their borrowers.

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The foregoing is only a summary of one of the many significant issues affecting bank holding companies and other financial institutions. If you have any questions about the foregoing or about other financial institution issues, please direct them to your regular contact at Troutman Sanders LLP or to any of the persons listed in the sidebar to this release.