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09.27.2010 | Legal Update

The President is expected today to sign into law H.R. 5297, the Small Business Jobs and Credit Act of 2010. Title IV of the bill creates the Small Business Lending Fund (Fund), a $30 billion fund to promote small business lending, and authorizes the Secretary of the Treasury to establish the Small Business Lending Fund Program (Program) to administer the Fund. All of the Program’s funds must be invested or committed by Treasury within one year from the date of enactment. The Program is separate and distinct from the Troubled Asset Relief Program (TARP) and no TARP-related restrictions apply to investments under the Program.

1.  Overview

The Program is available to depository institutions as well as depository institution holding companies in mutual or stock form. Treasury is authorized to purchase preferred stock, debt instruments or certain other obligations issued by eligible institutions with less than $10 billion in assets. Tier 1 capital treatment is likely but not certain. If an eligible institution is owned by a holding company, the top-tier holding company must be the applicant. An applicant must prepare a small business lending plan for the applicant’s regulators. Treasury will consult with the regulators during the application process. If an institution is approved, its primary federal regulator will issue specific underwriting requirements to be used in connection with the Program.

Capital invested by Treasury is intended to result in an increase in small business lending. The initial dividend or interest rate will be 5%. The coupon rate may decline within the first 2 years to as low as 1% as the invested capital is deployed in small business loans and as the institution’s small business lending increases relative to pre-investment levels. The coupon rate will increase to 7% after 2 years if the institution has not increased its small business lending, and to 9% after 4 ½ years in any case. The invested capital must generally be repaid within 10 years. Treasury may sell the obligations it holds to third parties. Terms and conditions of the Program are described in more detail below.

2.  Eligible Institutions

Institutions eligible to participate under the Program include banks, savings associations, bank holding companies, and savings and loan holding companies with assets of $10 billion or less as reported in their 2009 Q4 Call Reports. Credit unions are not eligible to participate in the Program.   

Nutter Notes: If an otherwise eligible bank or savings association is owned by a holding company, then the bank or savings association is not eligible to participate directly, but the holding company is eligible to participate. The bill provides that only the “top-tier” holding company is eligible to participate if there is a mid-tier holding company or multiple levels of holding companies.

3.  Other Eligibility Criteria

Institutions that have UFIRS composite ratings of 4 or 5 are not eligible to participate in the Program, nor are institutions that had UFIRS composite ratings of 4 or 5 within the prior 90 days.

Treasury will consult with each applicant’s primary federal regulator to determine whether the eligible institution may receive the investment. Treasury will also consider the views of state regulators regarding the financial condition of the institution in the case of applicants that are state-chartered institutions.

If a federal or state safety and soundness regulator would not recommend that an institution receive an investment under the Program, Treasury in consultation with the regulator may consider whether an investment under the Program would nevertheless be appropriate if matched with a private investment, and may condition approval under the Program on a matching private investment.

4.  Small Business Lending

The term “small business lending” means lending, as defined by and reported in an eligible institution’s Call Report, where each loan is one of the following types:

• commercial and industrial loans;
• owner-occupied non-farm, non-residential real estate loans;
• loans to finance agricultural production and other loans to farmers; and
• loans secured by farmland.

A loan in an original amount of more than $10 million or that goes to a business with more than $50 million in revenues is also not included in the definition of “small business lending.”

5.  Form of Investment

Treasury is authorized under the Program to purchase preferred stock and “other financial instruments” in eligible institutions. The term “other financial instruments” is not defined or further explained, except that “other financial instruments” are required to include “only debt instruments for which such eligible institution is fully liable or equity equivalent capital of the eligible institution,” and “such debt instruments may be subordinated to the claims of other creditors of the eligible institution.” Treasury will determine which instruments qualify under the Program.

6.  Tier 1 Capital Treatment

Although Treasury is authorized under the bill to make “capital investments” in eligible institutions by purchasing preferred stock and “other financial instruments” under the Program, the bill does not expressly provide that the preferred stock and “other financial instruments” will be treated as Tier 1 capital. However, there were colloquies on the House and Senate floors during passage of the bill in which the authors of the bill exchanged comments on the bill in an attempt to make clear that they intend that Treasury’s investments in participating institutions under the program be treated as Tier 1 capital.   

Nutter Notes: We are cautiously optimistic that Treasury will provide Tier 1 treatment for investments under the program as a result of the colloquies, despite the fact that the Collins Amendment in the Dodd-Frank Wall Street Reform and Consumer Protection Act instructs the banking agencies to give Tier 1 treatment in the future only to those capital instruments that are permissible components of Tier 1 capital for banks under existing capital rules. The Collins Amendment contains an exception for Capital Purchase Program investments by Treasury, which are similar in form (e.g., preferred stock) to the investments contemplated under the Small Business Lending Fund Program, because Capital Purchase Program investments would not otherwise satisfy the Collins Amendment’s Tier 1 capital requirements. No similar exception from the Collins Amendment’s restrictions, however, is contained in the Small Business Lending Fund bill for investments made under the Small Business Lending Fund Program.

7.  Maximum Investment Amount

An eligible institution with total assets equal to or less than $1 billion as reported in its 2009 Q4 Call Report may apply for a capital investment in an amount not exceeding 5% of risk-weighted assets, as reported in its Call Report for the quarter ending immediately before the date of its application under the Program, less the amount of any Capital Purchase Program and Community Development Capital Initiative investments.

An eligible institution with total assets of more than $1 billion but equal to or less than $10 billion as reported in its 2009 Q4 Call Report may apply for a capital investment in an amount not exceeding 3% of risk-weighted assets, as reported in its Call Report for the quarter ending immediately before the date of its application under the Program, less the amount of any Capital Purchase Program and Community Development Capital Initiative investments.   

Nutter Notes: In the case of an eligible institution that is a bank holding company or savings and loan holding company owning multiple depository institutions, total assets are determined based on the depository institution subsidiaries’ 2009 Q4 Call Reports, and risk-weighted assets are determined based on the depository institution subsidiaries’ Call Reports for the quarter ending immediately before the date of the parent company’s application under the Program.

8.  Small Business Lending Plan

At the time an eligible institution submits an application under the Program to Treasury, the applicant must submit to its primary federal regulator a small business lending plan that describes how the applicant’s “business strategy and operating goals” will allow it to address the needs of small businesses in the areas it serves, as well as a plan to “provide linguistically and culturally appropriate outreach, where appropriate.” State chartered banks are also required to provide copies of the small business lending plan to their state regulators. The plans will be treated as confidential supervisory information.

9.  Mandatory Underwriting Standards

The appropriate federal banking agency for an institution that receives funds under the Program is required within 60 days to issue guidance to the institution with prudent underwriting standards that “must be used for loans made by the eligible institution.”

10.  Dividend and Interest Rate

The preferred stock or other financial instrument issued to Treasury by a participating institution will carry an initial annual dividend or interest rate of 5%.

Within the first 2 years after the date of the investment, the rate may be adjusted based on the amount of the institution’s small business lending during that period. Changes in the amount of small business lending are measured against the average amount of small business lending reported by the institution in its Call Reports for 2009 Q3, 2009 Q4, 2010 Q1 and 2010 Q2, minus adjustments for charge offs and loans acquired by mergers and similar transactions.

The adjustments work as follows. During each calendar quarter within the first 2 years after the date of the investment, an institution’s rate may be adjusted in accordance with the following schedule, based on changes in the amount of the institution’s small business lending relative to the baseline average described above, as reported in its Call Reports.

• If the amount of the institution’s small business lending has increased by less than 2.5%, the dividend or interest rate will remain at 5%;
• If the amount of the institution’s small business lending has increased by 2.5% or more, but less than 5%, the dividend or interest rate will be 4%;
• If the amount of the institution’s small business lending has increased by 5% or more, but less than 7.5%, the dividend or interest rate will be 3%;
• If the amount of the institution’s small business lending has increased by 7.5% or more, but less than 10%, the dividend or interest rate will be 2%;
• If the amount of the institution’s small business lending has increased by 10% or more, the dividend or interest rate will be 1%.

In general, the rate based on Call Report data from the eighth calendar quarter after the date of the investment will be payable until the expiration of the 4 ½ year period that begins on the date of the investment.

If small business lending in the eighth calendar quarter after the date of the investment has remained the same or decreased relative to the baseline, the rate will be 7% until the expiration of the 4 ½ year period that begins on the date of the investment. In any event, the rate will increase to 9% at the end of the 4 ½ year period that begins on the date of the investment.

For a mutual institution or an S Corporation, Treasury may adjust the rate to take into account any different tax treatment of the securities.

11.  Rate Reduction May Not Apply to Entire Investment Amount

The reduction in the dividend or interest rate payable to Treasury is limited. The rate reduction will not apply to a dollar amount of the investment made by Treasury that is greater than the dollar amount increase in the amount of small business lending realized under the Program.   

Nutter Notes: For example, assume an institution with $500 million in risk weighted assets that has 20% of its balance sheet ($100 million) in small business loans takes a capital investment under the Program equal to 4% of its risk weighted assets ($20 million), but deploys only $10 million of it in new small business loans. The increase in small business lending is equal to 10% of its small business loan portfolio, which will drop the coupon rate to 1% on $10 million of the $20 million investment, but not on the additional $10 million. For this reason, an institution should consider aligning the amount of capital it seeks under the Program with the expected increase in its small business lending, despite the fact that a larger amount of capital may be available under the Program. An institution that takes an amount of capital in excess of its expected increase in small business lending may not realize the full rate reductions available under the Program.

12.  Repayment Deadline

The preferred stock or other financial instruments must include, as a term and condition, that the capital investment will be repaid not later than the end of the 10-year period beginning on the date of the capital investment or, at the end of the 10-year period, be subject to such additional terms as Treasury may prescribe. The preferred stock or other financial instrument must also provide that repayment in 10 years will not be required if it would adversely affect the capital treatment of the preferred stock or other financial instrument under current or successor capital requirements. Treasury may establish additional financial incentives to spur repayment.

13.  Taking Out TARP

Treasury will issue regulations and guidance to permit eligible institutions to use the Program to refinance securities issued to Treasury under the Capital Purchase Program, except that institutions that have missed more than one dividend payment under the Capital Purchase Program will not be eligible.

14.  Treasury May Transfer Securities

Similar to its authority under the Capital Purchase Program, Treasury may sell, dispose of, transfer, exchange or enter into repurchase or other financial transactions with respect to the preferred stock and other financial instruments issued to it under the Program.

15.  Further Changes to Program

If, after a capital investment has been made in an eligible institution, there is a change in law that modifies the terms of the investment or the Program in a materially adverse respect for the institution, the institution, after consulting with its primary federal regulator, “may . . . repay the investment without impediment.” No other recourse is provided.

Treasury is authorized to issue regulations and guidance to manage risks associated with the administration of the Fund.

16.  Other Restrictions

Each eligible institution that participates in the Program must certify that it is in compliance with certain Bank Secrecy Act requirements.

Each business receiving a small business loan from an approved institution under the Program must certify to the institution that principals of the business have not been convicted of certain sex offenses against minors.

Nutter Bank Report
Nutter Bank Report is a monthly electronic publication of the Banking and Financial Services Group of the law firm of Nutter McClennen & Fish LLP. Chambers and Partners, the international law firm rating service, has ranked Nutter’s Banking and Financial Services practice among the top banking practices in the nation. The 2009 Chambers and Partners review says that a “real strength of this practice is its strong partners and . . . excellent team work.” Clients praised Nutter banking lawyers as “practical, efficient and smart.” Visit the U.S. rankings at ChambersandPartners.com. The Nutter Bank Report is edited by Matthew D. Hanaghan. Assistance in the preparation of this issue was provided by Lisa M. Jentzen. The information in this publication is not legal advice. For further information, contact:

Kenneth F. Ehrlich                           Michael K. Krebs
kehrlich@nutter.com                       mkrebs@nutter.com
Tel: (617) 439-2989                        Tel: (617) 439-2288

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