Financial Services Law -- Nov 08, 2013

by Manatt, Phelps & Phillips, LLP

In This Issue:

FDIC Cautions Financial Institutions About D&O Insurance

Noting a rise in the use of exclusions in insurance policies for executives at financial institutions, the Federal Deposit Insurance Corporation urged banks to review existing policies and consider the appropriate level of coverage.

Financial institutions purchase directors and officers liability insurance to cover officer and director decision-making. “Appropriately structured D&O coverage can protect directors and officers that discharge their duties in a prudent manner and enable financial institutions to attract and retain qualified individuals to manage and oversee the operations of the institution,” the FDIC explained in FIL-47-2013, which applies to all FDIC-supervised banks and savings associations with total assets under $1 billion.

But in recent years, the agency has noted a rise in the use of exclusionary terms and provisions in D&O policies. These provisions result in less coverage for executives, which could have a negative impact on the recruitment and retention of well-qualified individuals, the FDIC said. “When such exclusions apply, directors and officers may not have insurance coverage and may be personally liable for damages arising out of civil suits relating to their decisions and actions,” the agency cautioned. “In some cases, directors and officers may not be fully aware of the addition or significance of such exclusionary language.”

In addition to increasing awareness about the issue and the importance of receiving expert insurance coverage advice, the financial institution letter offered several considerations for executive officers and boards of directors considering the purchase or renewal of a D&O policy, including specific questions like:

  • What protections do I want from my institution’s D&O policy?
  • What exclusions exist in my institution’s D&O policy?
  • Are any of the exclusions new, and if so, how do they change my coverage?
  • What is my potential personal financial exposure arising from each policy consideration?

“D&O liability insurance is an important risk mitigation tool for financial institutions, and it is vital for directors and senior executives to fully understand the protections and limitations provided by such policies,” the agency advised.

The FIL also reminded insured depository institutions and depository institution holding companies that they are prohibited from purchasing insurance policies that would pay or reimburse institution-affiliated parties for civil money penalties in either an administrative proceeding or civil action commenced by any federal banking agency. The regulations – 12 U.S.C. § 1828(k)(6) and 12 C.F.R. § 359.1(1)(2)(i) – do not contain an exception for cases where the affiliated party reimburses the depository institution for the cost of the civil money penalty coverage, the letter added.

To read FIL-47-2013, click here

Why it matters: The FDIC’s letter may not have been issued purely out of the goodness of the government’s heart. The proper amount of insurance coverage protects not just bank executives but the FDIC as well. Of particular concern to the FDIC is the use of “regulatory exclusions” which preclude coverage when an insured is facing an action taken by the FDIC or other regulatory agency. The exclusions caught the attention of the agency as it has increasingly filed suit over the last few years against the executives at failed banks. When the agency brings an action against a director or officer at a financial institution that does not have appropriate coverage – and the FDIC has brought 37 suits against directors and officers so far in 2013 – the executives involved have to bear the cost of defending the case, but the government faces an unlikely recovery as well. So D&O insurance coverage can benefit not only the insured but the FDIC also.

A Bit at a Time: Foothold in China Good News for Bitcoin

A foothold in the Chinese market led to an increase in trading value for Bitcoin, the virtual currency that has recently weathered some tough times.

The announcement that Jiasule, a unit of Chinese company Baidu, would begin accepting the virtual currency for payments resulted in Bitcoin’s jump from $140 to $163 on the Tokyo exchange, reaching $203 the last week of October.

Created by the solution of complex mathematical equations by computer users, Bitcoin touts itself as the first decentralized digital currency and has a current estimated value of about $1.5 billion. The virtual currency was created by Satoshi Nakamoto, an anonymous computer programmer.

Bitcoin has struggled to present a stable value. The currency took a big hit earlier this year when federal authorities in the United States shut down the notorious “black market” website Silk Road. Bitcoin’s value dropped from $140 to $110 following the arrest of the site’s founder, Ross William Ulbricht. Bitcoins also fluctuated dramatically in April, bouncing from $266 to $40 over just a few days.

Jiasule’s acceptance of Bitcoin not only boosts its current value but may also provide an entrée into the previously untapped Chinese market, which already ranks second for the number of bitcoins created per week (behind the United States). Jiasule is just one arm of Internet company Baidu’s business, and commentators noted that the company likely received some form of governmental approval to accept the virtual currency – meaning Bitcoin may now have the necessary stamp of approval to be accepted by other Chinese companies.

Why it matters: While Bitcoin remains a question mark for many in the financial services industry, the Jiasule deal could open the door to greater acceptance of the virtual currency in China. Although a growing number of reputable websites – like WordPress and Reddit – are accepting bitcoins, the currency needs to decrease its volatility to gain greater acceptance.

California to Banks: We Want You to Help Us Police Unlicensed Online Payday Lenders

Watch out for unlicensed online payday lenders, the California Department of Business Oversight (DBO) cautioned banks and credit unions – and immediately report any suspected illegal activity.

In an alert and letter to financial institutions in the state, Commissioner of Business Oversight Jan Lynn Owen said her department intends to keep a close eye on illegal online payday lending.

Online payday lending is the twenty-first century equivalent of payday loans. Instead of the borrower writing a check and the lender waiting to deposit the check until a specified date, online payday loans are funded and repaid from the borrower’s checking account via the Automated Clearing House network. Online lenders that do not have a valid license from the DBO “typically violate laws designed to protect borrower’s, such as charging rates higher than allowed under California statute,” Owen wrote. “Additionally, many are based overseas, meaning there is much less legal recourse for unsatisfied customers.”

Banks and credit unions should establish safeguards to prevent unlicensed payday lenders from gaining access to the ACH network, Owen advised, and monitor transactions to ensure compliance. Accepting debit and credit transactions from such lenders enables illegal activity in the state and may leave a financial institution open to liability.

“[T]o the extent a bank or credit union conducts any business with unlicensed payday lenders, such activity could implicate safety and soundness concerns,” potentially violating Bank Secrecy Act/anti-money laundering requirements if customer due diligence efforts do not confirm compliance with state licensing requirements, according to the letter.

Owen also referenced recent guidance from the Federal Deposit Insurance Corporation on the issue of facilitating illegal loans, in which the agency indicated its focus on whether banks are engaging in the proper oversight of such activities and appropriately managing and mitigating the risks.

“Financial institutions may also be, knowingly or unknowingly, facilitating a violation of state law by accepting debits and credits by unlicensed payday lenders from the ACH network,” Owen said. As the gatekeepers of the ACH network, banks and credit unions must play a role in protecting consumers.

Owen included a list of enforcement actions taken by the DBO with the name and location of unlicensed payday lenders, including Native American tribes in the United States, online-only companies, and foreign lenders.

The issue is a “central focus” of the DBO’s enforcement efforts, Owen noted. Examinations conducted by her office will review compliance with the DBO’s request for banks and credit unions to refrain from doing business with the entities listed in the letter, as well as discontinuing transactions with other unlicensed payday lenders.

To read the letter from Commissioner Owen, click here

Why it matters: Similar letters were released earlier this year by New York authorities as well as the FDIC, as referenced by Commissioner Owen. The letters demonstrate a new method of regulatory enforcement: By putting pressure on banks and other regulated third parties, the DBO hopes to prevent unlicensed payday lenders from doing business. As noted in Commissioner Owen’s letter, the unlicensed entities are often out of the DBO’s jurisdiction, either based overseas or operating as an Indian tribal entity. Unable to directly regulate the allegedly anticonsumer businesses directly, regulators like the FDIC and state authorities in California and New York put pressure on those businesses they can reach – in this case, banks and credit unions.

Federal Regulators Address Ability-to-Repay Rule

Will a creditor’s decision to originate only Qualified Mortgages under the Ability-to-Repay Rule run afoul of the disparate impact doctrine of the Equal Credit Opportunity Act and Regulation B?

Not necessarily, answered five federal regulators – the Consumer Financial Protection Bureau, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the National Credit Union Administration – in a jointly issued statement.

“In the Agencies’ view, the requirements of the Ability-to-Repay Rule and ECOA are compatible,” the agencies wrote. “[T]he agencies do not anticipate that a creditor’s decision to offer only Qualified Mortgages would, absent other factors, elevate a supervised institution’s fair lending risk.”

Implemented pursuant to the Dodd-Frank Act, the Ability-to-Repay Rule requires creditors to make a reasonable, good faith determination that a consumer has the ability to repay a mortgage loan before extending the consumer credit, by considering and documenting specified factors about the applicant and the loan. Certain “Qualified Mortgages” create a presumption of compliance under the Truth in Lending Act and Ability-to-Repay Rule, which takes effect in January 2014.

Given the safe harbor of originating Qualified Mortgages, lenders queried the regulators as to whether the decision to originate all or predominantly such loans would violate the disparate impact doctrine under ECOA.

There are several ways to satisfy the Ability-to-Repay Rule, the regulators wrote. Creditors should consider demonstrable factors like credit risk, secondary market opportunities, capital requirements, and liability risk, although how those factors are balanced remains up to the lender.

“As creditors assess their business models, the Agencies understand that implementation of the Ability-to-Repay Rule, other Dodd-Frank regulations, and other changes in economic and mortgage market conditions have real-world impacts and that creditors may have a legitimate business need to fine-tune their product offerings over the next few years in response,” the agencies said.

In fact, the existing business models for some lenders are such that all of the loans they originate will already satisfy the requirements for Qualified Mortgages, the statement noted.

“With respect to any fair lending risk, the situation here is not substantially different from what creditors have historically faced in developing product offerings or responding to regulatory or market changes,” the agencies wrote. The statement analogized the present situation to historical rule changes – like new regulations issued in July 2008 on “higher-priced mortgage loans” which resulted in some creditors changing their offerings. “We are unaware of any ECOA or Regulation B challenges to those decisions.”

However, the agencies cautioned creditors to “continue to evaluate fair lending risk as they would for other types of product selections, including by carefully monitoring their policies and practices and implementing effective compliance management systems. As with any other compliance matter, individual cases will be evaluated on their own merits.”

This may leave lenders in more of a quandary than first appears. While it is helpful to know that limiting one’s lending to Qualified Mortgages will not inherently violate fair lending standards, the agencies have not provided guidance as to how such a limited program can be managed so as to avoid those violations. The rigorous requirements of Qualified Mortgages are unlikely to be satisfied by many lower-income applicants, and in many communities – given the realities of demographics – this will translate to less eligibility by minority applicants. While the regulators’ disparate impact analysis has been under attack, the Mount Holly Gardens case, in which the Supreme Court might have resolved that issue, now (as of November 6, 2013) appears to be in the last stages of resolution by settlement. A settlement would remove that case from the Supreme Court’s calendar. Assuming disparate impact remains part of the regulatory landscape, it can be a landmine for lenders that choose to limit themselves to Qualified Mortgages.

To read the interagency statement, click here

Why it matters: Creditors may be unsure how to feel after reading the interagency statement. While the agencies said fair lending risks would not be elevated for creditors making only Qualified Mortgage loans, the statement was cautioned with an “absent other factors.” This appears to leave the door open for creditor liability in a challenge brought by protected class applicants alleging disparate impact.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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