Banking and Finance Law Report : Banking & Finance Lawyer & Attorney : Porter Wright Morris & Arthur Law Firm : Bankruptcy, Commercial Lending

With certain limitations, a bank may own real estate it acquires by foreclosure, conveyance in lieu of foreclosure, or other legal proceedings in satisfaction of a debt previously contracted. Ownership of such property can create potential liability for the bank in a number of ways, though most commonly from personal injuries which occur on the property (another possibility with the potential to be very costly is environmental liability). While insurance can mitigate much of this risk, it has its limitations and a bank has options to be further protected.

One way to mitigate the risk is for a bank to own such property in an operating subsidiary wholly owned by the bank. Ownership of the property in an operating subsidiary would help limit the liability exposure to the assets of the subsidiary and protect the bank itself. Thus, the bank's income and assets from other activities are insulated from the risks associated with property ownership. While common for large banks, many small banks do not have this level of protection in place, often because of the administrative burden associated with establishing a wholly owned subsidiary.

Under Ohio law, establishing an operating subsidiary requires a bank to submit a letter of notification to the superintendent of financial institutions in accordance with OAC 1301:1-3-10(B). The bank then must wait thirty (30) days for the superintendent to review the notification and, unless notified to the contrary, may establish the operating subsidiary for holding property. The operating subsidiary will be subject to the same laws and rules applicable to the bank.

With the large amount of property owned by banks in this current economic environment, many banks could face liability for personal injuries or other harms which occur related to the property. It may be in their best interest to act now and insulate the bank itself from those potential liabilities by establishing a wholly owned operating subsidiary, before it's too late.

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In October, the Consumer Financial Protection Bureau published its first supervision examination manual which will be of interest to bankers and other financial service executives.

On one level, the manual is fairly pedestrian and may contain little surprising in that most bankers have a fairly extensive appreciation of (and experience with) an examination process. And, of course, the Bureau has direct supervisory authority only over the roughly 100 large banks, thrifts, and credit unions that have assets more than $10 billion.

What should be interesting to many bankers, however, is the insight the Manual provides into the examination approach of the Bureau, an approach that will doubtlessly influence and inform the practices and procedures of all other financial institution regulators, large and small. Essentially, the Manual describes the Bureau's process for risk assessment: first there will be the establishment of the inherent risk of a particular "product" line for consumers and then there will be an assessment of an entity's set of quality controls to manage and mitigate the risks.

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 A new interim federal rule effective May 1, 2011 protects from garnishment a portion of certain federal benefits direct-deposited into judgment debtor's account within two months of the garnishment. The interim rule requires banks, credit unions and other financial institutions to change the way they process and respond to garnishments of accounts containing federal benefits, including Social Security benefits, SSI benefits, Civil Service Retirement benefits, Federal Employee Retirement Systems, VA benefits and Federal Railroad retirement, unemployment and sickness benefits. The interim rule does not protect from garnishment federal benefits paid into a judgment debtor's account by check, cash, money order or other non-direct deposits, and the interim rule preempts inconsistent State or local garnishment laws and exempts certain federal and state child support garnishments.

The interim rule addresses the common practice of financial institutions that freeze a judgment debtor's account in response to a garnishment without examining whether the account contains exempt federal benefit payments. This practice can leave judgment debtors who receive federal benefits without income or the ability to meet their immediate financial needs. 

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The U.S. Senate overwhelmingly passed (95–5) the America Invents Act (formerly titled the Patent Reform Act of 2011) (S.23 or AIA), on March 8, 2011. This legislation represents a major patent reform initiative and is quite possibly the most significant patent reform since the 1952 Patent Act. This legislation could have significant impact on financial institutions.

The headline change ofthe AIA is that a patent would be awarded to the first-to-file a patent application rather than to the first-to-invent the invention. This should favor large financial institutions who are regularly active in patenting innovations because they will have the resources and systems in place to win a race to the patent office. Small financial institutions or those not regularly active in patenting innovations will need to adapt to more quickly react to their innovations or risk losing the race. Perhaps a more significant impact on financial institutions due to this change is that the first-to-file system makes prior users vulnerable to patent infringement. A financial institution can use an innovation for years as a trade secret and then be liable for patent infringement when another party patents that innovation. This could be very problematic in the financial industry which has largely considered its business methods and software as either unpatentable or better protected by trade secrets. As a result, the financial industry should be lobbying for prior user rights to be added to this legislation.

Other aspects of the AIA significant to banks and financial institutions are the creation of a proceeding to challenge business method patents in the patent office and the increased ability for third parties to oppose patents during pendency and after issuance. The AIA temporarily creates a proceeding within the patent office in which business method patents can be challenged by anyone. This will be important to financial institutions because the ever increasing threat of infringement suits based on business method patents that appear as though they should be invalid. This proceeding should provide an avenue to invalidate such patents that is less costly than litigation. The AIA also enables the public to provide prior art to the patent office at any time. This should reduce the number of patents that issue that are clearly not new innovations assuming financial institutions watch the pending applications and make prior art submissions to the Patent Office when relevant.

The AIA now awaits review and passage by the U.S. House of Representatives. Initial hearings by the House Judiciary Committee Subcommittee on Intellectual Property, Competition, and the Internet raised questions about, among other things, the lack of prior user rights and the inclusion of the proceeding to challenge business method patents.  Check out the Porter Wright Technology Law Source blog post for more information regarding the AIA.

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Congress’ recent passage and President Obama’s signing of the “Dodd-Frank Wall Street Reform and Consumer Protection Act” provides significant incentives for financial industry whistleblowers to assist the government root out fraudulent practices and other unlawful conduct in the industry. Supporters of the Dodd-Frank Act are praising its expansive whistleblower protections as a necessary good corporate-citizen tool to help the government ensure a financial crisis like 2008 never happens again.

Under the Dodd-Frank Act, whistleblowers in publicly traded companies are provided significant personal financial incentives to disclose to the SEC “original” information concerning securities laws violations occurring within their companies. “Original” information means the information must be derived from the whistleblower’s independent knowledge or analysis and cannot be known to the SEC from any other source. The available financial reward — or “bounty” — available to a qualifying whistleblower will range from 10% to 30% of any financial recovery in excess of $1,000,000 that the SEC obtains from the targeted corporation, including the amount of any penalties, disgorgement and interest.

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On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). Although the Act focuses primarily on the financial industry, the Act contains a section that requires the Securities and Exchange Commission (“SEC”) to publish rules that direct the national securities exchanges and associations to prohibit the listing of any security of an issuer that does not develop and implement an appropriate clawback policy.

Specifically, a clawback policy must provide that an issuer that is required to restate its financial statements because of a material financial reporting violation must recover from certain executive officers the amount in excess of what would have been paid to them under the issuer’s restated financial statements. No showing of misconduct or negligence on the part of the affected executives is required. In other words, public companies must recover the excess, if any, between the actual pay-out under the original financial statements and the amount payable under the restated financial statements. This policy must apply to any current or former executive officer who received incentive-based compensation (including stock options) during the three-year period preceding the date on which the restatement is required. The Act also requires that companies disclose this clawback policy to shareholders. Any former employee who was an executive officer at any time apparently will be subject to the clawback policy without regard to whether he or she was an executive officer at the time of the restatement or whether the compensation that was received had been earned prior to the three-year period.

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Trying to understand the whole of H.R. 4173, the Dodd-Frank Wall Street Reform and Consumer Protection Act, is tough. The Act is long, complex and if you are focusing directly on the credit crisis, the Act is not particularly intuitive. Much of the Act has only a tangential relationship to the core purpose of the bill, preventing a reoccurrence of the credit crisis. Here is a brief, title by title summary to help, and along the way, I will point out the more important sections for community bankers.

I. Financial Stability – addresses the core purpose of the bill by creating a new oversight regulator, the Financial Stability Oversight Council. This council of regulators will monitor the financial system for "systemic risk" and will determine which entities pose significant systemic risk. Generally speaking, it will make recommendations to regulators for the implementation of the increased risk standards, also known as prudential regulation, to be applied to bank-holding companies with total consolidated assets of $50 billion or more and to designated nonbanks.

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Is your phone ringing off the hook? Then you’d better check your bank account. According to the Federal Bureau of Investigation, a new “telephone denial-of-service” attack is combining high-tech and low-tech fraud techniques to steal money from the bank accounts of unsuspecting victims.

As reported in the alert issued by the FBI, the scam begins with the suspect obtaining a victim’s personal and banking information, perhaps including bank account numbers, PINs, and passwords. Scammer can obtain a victim’s personal and banking information in a variety of ways, such as through phishing emails, social engineering tactics, or malware surreptitiously installed on a person’s computer.

Once the scammers have the victim’s personal information, they begin tying up the victim’s telephone line by using automated resources to place hundreds or thousands of calls to the victim’s telephone, not unlike a Distributed Denial of Service attack aimed at a computer network that overwhelms a computer with requests for information resulting in a slowing or failure of the network. 

While the victim is busy dealing with the onslaught of telephone calls, the scammers quickly drain the victim’s bank account using the previously obtained personal and banking information to gain access to the account. If the banking institution calls its customer to verify the transactions they find the victim’s telephone line to be busy. In some cases, scammers are brazen enough to change a victim’s contact information listed with the bank. As a result, calls from a bank to verify fraudulent transactions are redirected to the scammers. According to the FBI, “[b]y the time the victim or the financial institution realize what happens, it’s too late.”

Although the FBI did not disclose how much money it believes to have been stolen in this matter, it highlighted the case of a Florida dentist who lost $400,000 from his retirement account through such a scam. Based on the Bureau’s alert, it appears that such crimes will continue to increase in frequency.

Ultimately, the telephone calls serve as a diversion to occupy the victim and a barrier to prevent a bank from verifying the authenticity of fraudulent transactions. If you believe you have been targeted in such a scam, or if you believe you have been the victim of any other online fraud, visit the Internet Crime Complaint Center for resources and guidance.

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On February 23, 2010, the Securities and Exchange Commission began what may become radical revisions to the regulation of money market funds when it adopted a number of significant changes to its rules governing money market funds. The changes were accompanied by a statement from the SEC chairman that indicated more regulatory change is on the way. SEC Release No. IC-29132 (Feb. 23, 2010) is online.

The new rules are generally intended to increase investor protections by increasing regulatory oversight of money market funds. For example, among other things, the new rules establish:

• liquidity requirements for money market funds (a daily cash or equivalent requirement of 10 per cent);
• a new restriction on the ability of funds to acquire illiquid securities;shorter maturity limits for securities held by money market funds;
• “know your investor” procedures requiring funds to hold liquid securities to meet foreseeable redemptions;
• a requirement for periodic stress testing to assess ability of a fund to maintain a stable net asset value upon the occurrence of events such as a sudden increase in interest rates;
• andnew disclosure requirements including a monthly report of holdings to the Commission and a monthly posting of holdings online.

In many of these areas there previously was little or no regulation. The rules are effective May 5, 2010, but a number of the new requirements are phased in over two years, including a new requirement that funds be able, as a matter of processing capability, to process transactions at prices other than a stable net asset value.

SEC Chairman Mary Schapiro’s statement on the new rules is online.

Ms. Schapiro’s remarks indicate that the SEC is continuing to study the possibility of floating net asset value money market funds, among other changes. She indicated the market place should expect further changes when she characterized the current regulatory changes as “important initial steps toward making money market funds less vulnerable to ‘runs’.” (Italics supplied.) One further change under study is the establishment of a private liquidity facility for money market funds in times of stress.

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January 21, 2010, President Obama proposed reforms to the financial system designed to ensure no bank, or financial institution that contains a bank, will own, invest in, or sponsor a hedge fund, private equity fund, or proprietary trading operation for the bank’s own profit. The new reforms, known as the Volcker Rule after former chair of the Federal Reserve Board, Paul Volcker, are intended to prevent banks from engaging in what are now perceived as risky investments.

How the Volcker Rule will be drafted and applied is unclear. At a minimum it seems that banks may have to halt investments that use solely the bank’s capital. Banks may therefore have to divest their proprietary trading desks, although most banks have significantly smaller proprietary trading desks than they did prior to the economic crisis.

What constitutes proprietary trading operations under the Volcker Rule is unknown. For example, do such activities include the practice of facilitating trading for clients and investing alongside clients? Additionally, it is unclear whether only wholly-owned bank funds would be prohibited or any bank involvement in a hedge fund or private equity fund above a certain threshold. One approach, which would be a broad interpretation of the Volcker Rule, would be to prohibit any trading activity that could affect a bank’s balance sheet.

President Obama has pledged to work with Congress to implement the Volcker Rule as part of a comprehensive financial reform bill. The dynamics of the bill should have a direct effect on whether some banks will be willing to cease being a bank holding company in order to keep their trading and investment business.

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In November the House Financial Services Committee passed an amendment to the proposed Investor Protection Act, H.R. 3817, that would exempt non-accelerated filers from providing auditor attestation of internal control over financial reporting. Public holding companies for some community banks may be affected. If passed, the bill as amended would provide significant relief for smaller reporting companies which are, generally speaking, companies with a public float of less than $75 million.

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For bankers, November 2, 2009, is a key date to remember in conjunction with unlimited FDIC deposit insurance on noninterest-bearing transaction accounts. By that date, bankers must decide to opt out of the program, or not. For bank customers, November 16, 2009, is a key date because by that date banks that opt out must post notices to that effect.

You will remember the origins of this program: The Transaction Account Guarantee (TAG) program was established in October 2008 in the midst of a severe disruption in the credit market. The TAG program is one of two elements of the FDIC’s Temporary Liquidity Guarantee Program. The other element is the Debt Guarantee Program that provides a guarantee for bank-issued senior debt. The ability to issue debt under that program was scheduled to expire on June 30, 2009 and has been generally extended for four months.

On August 26, 2009, the Board of Directors of FDIC approved its Final Rule on the extension of unlimited deposit insurance for transaction accounts under TAG, and the rule is effective October 1, 2009. The program has been extended to June 30, 2010 (from December 31, 2009). 

Each financial institution that participates will be subject to certain FDIC fees during the extension. The Final Rule provides that financial institutions can opt out of the program by November 2, 2009, and it describes the procedures required for a financial institution to make an election to opt out. The fees to be paid by participating institutions are based on the entity’s Risk Category under the FDIC’s risk-based premium system and range from 15 basis points to 25 basis points (annualized) multiplied by the amounts held in noninterest-bearing accounts that exceed the current deposit insurance limit of $250,000.

The rule also contains requirements for financial institutions to provide notices to customers with respect to the financial institution’s participation in TAG. In summary, the notices must be prominent and must be posted in the lobby of the main office, in each branch office and on the financial institution’s website if it offers internet deposit services. The notice must state whether the institution is participating in the transaction guarantee program and, if so, that the funds held in noninterest-bearing transaction accounts are guaranteed in full by the FDIC. 

In addition, the rule requires certain disclosures of institutions that use sweep arrangements or other actions that result in funds being transferred or reclassified to an account that is not guaranteed under TAG. For example, funds swept into an interest bearing account would not be covered. These disclosures must advise customers that such arrangements would void the FDIC’s insurance guarantee with respect to the swept, transferred, or reclassified funds.

The FDIC’s Final Rule is available here.

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The FDIC has updated its regulatory advice concerning changes for insurance coverage of sweep accounts. Bankers, corporate treasurers and CFO’s should carefully consider the impact on sweep accounts of recent changes in the FDIC’s deposit insurance of these accounts. 

On July 6, the FDIC issued a Financial Institution Letter (FIL-39-2009) consisting of frequently asked questions to update the rule change that was final in January 2009 and published here. The new Letter, intended to answer common questions from bankers, covers:

• The types of sweep accounts covered by the disclosure requirements,
• The disclosures required by the rule.
• The frequency of required disclosures.
• The principles used to determine how swept funds will be treated in the event of failure.
• The requirements for a properly structured repo sweep.

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The Board of Governors of the Federal Reserve recently approved a final rule amending Regulation Z (Truth in Lending) and the Home Ownership Equity Protection Act (HOEPA).   The purpose of the new rule, according to Federal Reserve Chairman Ben Bernanke, is to "protect consumers from unfair or deceptive acts and practices in mortgage lending, while keeping credit available to qualified borrowers and supporting home ownership."  The highlights of the new rule are as follows:

The final rule imposes certain restrictions on lenders in relation to "higher priced mortgages."  This term is broadly defined to capture virtually all loans in the subprime market while at the same time excluding loans in the prime market.  Lenders are prohibited from making a loan without verifying the borrowers' ability to repay the loan from income and assets other than the mortgaged property.  Targeted directly at the practice of offering adjustable rate mortgages (ARMs) with low initial payments, compliance with this regulation requires lenders to assess repayment ability based on the highest scheduled payments in the first seven years of the loan.  In a similar vein, prepayment penalties are prohibited when payments may change within the initial four years of the loan.  More importantly, lenders may incur liability for violating these standards on a case-by-case basis, as borrowers will not have to demonstrate that any violations are part of a larger pattern or practice. 

Advertising for all mortgage loans, regardless of type, priority or the nature of the collateral, must contain additional information about rates, monthly payments and other loan features, such as the effect of discounted rates, the existence of a balloon payment, deductibility of certain kinds of interest for tax purposes, and the extent of promotional or introductory rates.  Certain specific advertising practices thought to be misleading or deceptive are also banned. 

Compliance with this final rule becomes mandatory on October 1, 2009.

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