FDIC Issues Final Rule on ILCS: Strengthens Pathway for Companies Seeking Bank Charters

December 28, 2020

The Federal Deposit Insurance Corporation (“FDIC”) issued a new rule formalizing requirements for industrial loan companies (“ILCs”).[1] The requirements in the final rule are mostly in line with the FDIC’s longstanding expectations as well as the notice of proposed rulemaking issued by the FDIC in March 2020. The proposed rule was issued a day before the FDIC provided its first two ILC deposit insurance approvals since before the ILC moratorium. Those approvals show an application of the rules we discuss below. Finally, the codification of the requirements provides companies with much needed certainty and potentially signals a greater willingness on the part of the FDIC to accept future ILC proposals.

ILC charters allow companies to provide banking products and services to their customers without their parents qualifying as bank holding companies. Consequently, the ILC parent is not subject to the business activity restrictions in the Bank Holding Company Act (the “BHC Act”) or the capital requirement of Basel III.  This is why many financial technology (“FinTech”) companies have shown significant interest in these charters. Traditional companies, such as Walmart, GE, and BMW, have also publicly announced desires over the years to pursue the ILC option for offering financial services.

Summary of Final Rule

The final rule applies to any ILC that becomes a subsidiary of a Covered Company on or after April 1, 2021. Covered Company generally refers to any company that directly or indirectly controls an ILC that is not subject to consolidated supervision by the Federal Reserve Board.[2] The practices codified in the final rule allow the FDIC to supervise ILCs and their parent companies in order to mitigate risk to the Depository Insurance Fund that may otherwise exist without adequate federal oversight. It also serves to ensure that the parent of any ILC is able to serve as a source of financial and managerial strength for the subsidiary, a longstanding requirement for bank holding companies.[3]

The final rule involves two primary components: (1) a Covered Company, and potentially its controlling shareholder, must enter into a written agreement with the FDIC that covers at least eight specific commitments; and (2) ILC subsidiaries of Covered Companies are prohibited from engaging in certain activities without the FDIC’s prior written consent.

While most of the changes in the final rule are in line with the proposed rule issued in March, there are three substantive changes. First, the permitted representation on the board of a subsidiary ILC by the Covered Company was increased from no more than 25% to less than 50%. Second, restrictions on the appointment of senior executive officers and directors of the ILC only apply during the first three years after becoming a subsidiary of a Covered Company.[4] Third, Covered Companies will be required to engage in additional reporting on systems that are designed to protect the security, confidentiality, and integrity of consumer and nonpublic personal information.

The final rule does not apply retroactively to existing ILCs. It also does not apply to (i) subsidiaries of entities subject to consolidated federal oversight, or (ii) ILCs that are owned by individuals, and not by another company.[5] However, the final rule could apply to existing ILCs in the future in the event of a change in control or merger.

Written Agreement Requirement

Following the effective date of the rule, an ILC is prohibited from becoming a subsidiary of a Covered Company unless the Covered Company, the ILC, and potentially the controlling shareholder of the Covered Company enter into a written agreement with the FDIC that specifically addresses eight commitments specified in the final rule.[6]

The eight commitments that must be covered in the Agreement are as follows:

  1. submit to the FDIC an initial listing of all of the Covered Company’s subsidiaries and update such list annually;
  2. consent to the examination by the FDIC of the Covered Company and each of its subsidiaries (such examinations are intended to confirm that the parent companies can meet their source of strength obligations);
  3. submit to the FDIC an annual report describing the Covered Company’s operations and activities, in the form and manner prescribed by the FDIC, and such other reports as may be requested by the FDIC;
  4. maintain such records as the FDIC may deem necessary to assess the risks to the subsidiary ILC or to the Deposit Insurance Fund;
  5. cause an independent audit of each subsidiary ILC to be performed annually;
  6. limit direct and indirect representation of the Covered Company on the board of directors of each subsidiary ILC to less than 50 percent of the members of such board of directors;
  7. maintain the capital and liquidity of the subsidiary ILC at such levels as the FDIC deems appropriate, and take such other actions as the FDIC deems appropriate to provide the subsidiary ILC with a resource for additional capital and liquidity (such provisions were previously required as Capital and Liquidity Maintenance Agreements or “CALMAs”); and
  8. execute a tax allocation agreement with its subsidiary ILC that expressly states that an agency relationship exists between the Covered Company and the subsidiary ILC with respect to tax assets generated by such ILC, and that further states that all such tax assets are held in trust by the Covered Company for the benefit of the subsidiary ILC.

In addition to these eight required commitments, the FDIC may require additional written commitments or restrictions, as deemed appropriate by the FDIC, including, but not limited to, a contingency plan.[7] Justifying its decision to retain the contingency plan requirement, the FDIC specifically highlighted that such a plan enables the FDIC, the Covered Company, and the ILC to better understand the relevant interdependencies, operational risks, and other circumstances that could potentially create safety and soundness concerns—and especially enables the FDIC to understand (1) how an ILC resolution can be best achieved and (2) how to disentangle the ILC from the parent if necessary. The rule also emphasizes the FDIC’s authority to tailor the requirements of any such contingency plan.

Restrictions on ILC Activities Requiring Explicit FDIC Approval

In addition to the agreement requirement for parent companies of ILCs, the final rule also creates certain restrictions on ILCs directly. An ILC controlled by a Covered Company may not engage in the following activities without the FDIC’s prior written approval:

  1. make a material change in its business plan after becoming a subsidiary of such Covered Company;
  2. add or replace a member of the board of directors, board of managers, or a managing member, as the case may be, of the subsidiary ILC during the first three years after becoming a subsidiary of such Covered Company;
  3. add or replace a senior executive officer during the first three years after becoming a subsidiary of such Covered Company;
  4. employ a senior executive officer who is, or during the past three years has been, associated in any manner (e.g., as a director, officer, employee, agent, owner, partner, or consultant) with an affiliate of the ILC; or
  5. enter into any contract for services material to the operations of the ILC (for example, loan servicing function) with such Covered Company or any of its subsidiaries.

Approvals

A day after releasing the Proposed Rule, the FDIC announced the approval of ILC deposit insurance applications from Square and Nelnet. Because the final rule is in most ways the embodiment of the proposed rule, would-be applicants should carefully review these Approvals and consider how these Approvals might impact an ILC application. An overview of each of the Approvals is below.

Square

Square, Inc. (“Square”) was formed in 2009 as a payment services provider to enable businesses to accept card payments. The platform has since been expanded to include point-of-sale payments, financing, crypto-services and other services. Square’s payment wallet has seen tremendous growth during COVID-19. The bank, Square Financial Services, Inc., would originate commercial loans to merchants that process card transactions through Square, Inc.’s payments system. The bank’s business model would be centered on the origination and sale of small commercial loans. The bank proposes to market its loan and deposit products primarily to existing Square merchants. The bank will operate from a main office located in Salt Lake City, Utah and received approval from the Utah Department of Financial Institutions on March 17, 2020.[8] Square filed its initial ILC application with the FDIC on September 7, 2017. It subsequently withdrew the application on April 6, 2018, and refiled the application on December 19, 2018.

The deposit approval order for Square (available here) lists 28 conditions, the most material of which include:

  1. minimum leverage ratio of 20% (Condition 2(iii));
  2. Square, Inc. and Jack Dorsey[9], as the controlling shareholder of Square, Inc., enter into a CALMA (Condition 3);
  3. Square, Inc. enters into a Parent Company Agreement (“PCA”) (Condition 3);
  4. the bank must have a Chief Risk Officer and Chief Operating Officer at the time the bank opens (Condition 8);[10]
  5. FDIC approval of compensation for directors and executives (Condition 11);
  6. independent audit of the bank annually for the first three years of operation (Condition 15);
  7. an open ended requirement to submit an annual business plan for FDIC approval (Condition 16);
  8. no dividends from the bank for the first three years (Condition 19); and
  9. adopting a Community Reinvestment Act plan (Condition 20).

While neither the PCA nor the CALMA are public, Mr. Gruenberg’s dissent from the Square application approval (available here) mentions some of the provisions in the PCA and CALMA, which include:

  1. maintaining a third-party line of credit for the benefit of the proposed bank;
  2. limit its representation on the bank’s board of directors to no more than 25 percent (this would now presumably be less than 50 percent);
  3. purchasing any loan from the proposed bank at the greater of cost or fair market value, if deemed necessary by the FDIC or the proposed bank;
  4. establishing and maintaining a $50 million reserve deposit at an unaffiliated bank;
  5. adopting a contingency plan that describes actions Square would take if it were ultimately unable to serve as a source of strength; and setting forth options for the orderly wind down of the Bank through liquidation, sale, or merger, without entering receivership (a so-called living will);
  6. consenting to the FDIC’s examination of Square and its subsidiaries; and
  7. engaging a third party to review and provide periodic reports concerning the effectiveness of Square’s complaint response system and addressing them, if any material concerns are identified.

Mr. Gruenberg’s dissent also mentioned that FDIC staff have delegated authority to modify any of the conditions of the Square approval. This is a departure from precedent in that amendments to earlier ILC deposit insurance approvals required approval of the FDIC board. 

Nelnet 

Nelnet, Inc. (“Nelnet”) is a $24 billion, publicly traded financial and technological services company providing education-related products and services to students, families, schools, and financial institutions. Nelnet was founded in 1978 to service federal student loans. In the years following its founding, Nelnet became a leading originator, holder, and servicer of federal student loans. In 2010, however, the federal law was changed to discontinue new loan originations by private firms. That served as an impetus for Nelnet to seek to establish a bank to originate private student loans. Nelnet is affiliated with a chain banking organization consisting of six state-chartered banks with combined assets of more than $6 billion that has had a positive record of performance for over 25 years.

Nelnet seeks to establish an internet-based industrial bank in which it would originate, refinance, and service private student and consumer loans and offer deposit products nationwide. The proposed bank would operate from a single location, and plans to market its lending products through various channels, including the internet, direct mail and direct to consumer marketing as well as campus-based marketing, and marketing to families using other Nelnet products and services. The bank expects to offer deposit products as companion products to lending products and would develop a deposit base through Nelnet’s existing client relationships within other lines of business. Nelnet filed its initial ILC application with the FDIC on June 28, 2018. It subsequently withdrew the application on September 21, 2018, and refiled the application on November 12, 2019.

The deposit approval order for Nelnet (available here) lists 26 conditions (the majority of which are identical to Square’s conditions), the most material of which include:

  1. a leverage ratio of 12% (Condition 2);
  2. Nelnet, and Michael Dunlap, as the controlling shareholder of Nelnet, enter into a CALMA (Condition 3);
  3. Nelnet enters into a PCA (Condition 3);
  4. FDIC approval of compensation for directors and executives (Condition 9);
  5. independent audit of the bank annually for the first three years of operation (Condition 12);
  6. prior approval for any material deviations from the approved business plan for a period of three years (but no open ended requirement to submit an annual business plan, unlike Square) (Condition 13);
  7. no dividends from the bank for the first three years (Condition 16); and
  8. adopting a Community Reinvestment Act plan (Condition 17).

While neither the PCA nor the CALMA are public, Mr. Gruenberg’s statement in support of the Nelnet application (available here) mentions some of the provisions in the PCA and CALMA, which include:

  1. establishing and maintaining a $40 million deposit account at the bank;
  2. adopting a contingency plan that describes actions Nelnet would take if it were ultimately unable to serve as a source of strength; and setting forth options for the orderly wind down of the bank through liquidation, sale, or merger, without entering receivership[11];
  3. limiting its representation on the bank’s board of directors to no more than 25 percent (again, this would now presumably be less than 50 percent); and
  4. consenting to the FDIC’s examination of Nelnet and its subsidiaries.

It appears that Nelnet’s demonstrated profitability, including profitability through the financial crisis, was a key fact for Mr. Gruenberg to support the Nelnet application (and not the Square application). Mr. Gruenberg’s statements in connection with each of the Square and Nelnet applications also mention that FDIC staff have delegated authority to modify any of the conditions of the Square approval. Again, this is a departure from precedent in that amendments to earlier ILC deposit insurance approvals required approval of the FDIC board. We view this change as favorable to future ILCs.

Applicants should evaluate the conditions listed in the Square and Nelnet orders and be aware that the FDIC might impose all of the same conditions on them that it imposed on Square and Nelnet.

Closing Considerations

The final rule has already attracted both praise and criticism. The criticism mainly stems from concerns that large commercial companies will have an easier path to become banks. As noted in the final rule “whether commercial firms should continue to be able to own [ILCs] is a policy decision for Congress to make.” Critics have also questioned whether ILCs can be supervised in a safe and sound manner without consolidated supervision by the Federal Reserve. While the Federal Reserve may not have oversight over ILC parent companies, the FDIC is a capable regulator that has shown significant interest in ensuring federal bank regulation is appropriate for the digital age—particularly under Chairwoman McWilliam’s strong leadership.[12]

Companies interested in a de novo banking charter should consider the ILC option. The FDIC’s final rule is a welcome development as companies need certainty when pursuing what is often a long and complex process.

 

[1] Final rule is available at: https://www.fdic.gov/news/board/2020/2020-12-15-notice-dis-b-fr.pdf. For convenience, this alert uses the term ILC to also refer to industrial banks.

[2] “Covered Company” is more formally defined in the final rule to mean “any company that is not subject to Federal consolidated regulation and supervision by the FRB and that controls an industrial bank (i) as a result of a change in bank control pursuant to section 7(j) of the FDI Act; (ii) as a result of a merger transaction pursuant to section 18(c) of the FDI Act; or (iii) that is granted deposit insurance by the FDIC pursuant to section 6 of the FDI Act, in each case on or after April 1, 2021.” “Control” exists if the company has the power, directly or indirectly, (i) the ability to vote 25% or more of any class of voting shares of any industrial bank or any company that controls the industrial bank (i.e., a parent company), or (ii) to direct the management or policies of any industrial bank or any parent company. Presumptions of control may occur at lesser ownership, interrelationships or influence. See, e.g., https://www.federalreserve.gov/aboutthefed/boardmeetings/files/control-rule-fr-notice-20200130.pdf.

[3] 12 U.S.C. 1831o-1(a) and (b). The Dodd-Frank Act codified the Federal Reserve’s “Source of Strength Policy.” The source of strength requirement also applies to bank and savings and loan holding companies.

[4] Such timeframe is in line with the FDIC’s de novo time period, which is currently three years.

[5] To support the limited application, the FDIC specifically concluded that ILCs that do not have parent companies generally do not present the same potential risks as ILCs that are owned by companies. The term “company” is broadly defined by the BHC Act to refer to almost any entity except for certain trusts.

[6] If multiple Covered Companies control a specific industrial bank, each such Covered Company is required to execute a written agreement.

[7] The contingency plan should set forth, at a minimum, recovery actions to address potential significant financial or operational stress that could threaten the safe and sound operation of the industrial bank and one or more strategies for the orderly disposition of such industrial bank without the need for the appointment of a receiver or conservator. Such disposition may include, for example, sale of the industrial bank to, or merger with, a third party.

[8] See, https://dfi.utah.gov/general-information/application-status/.

[9] The proposed rule suggested that an agreement with a controlling shareholder would be limited to an agreement “causing the [Parent] to fulfill its obligations under the written agreement, through voting his or her shares, or otherwise” rather than imposing independent financial commitments. However, because the agreement is private, we cannot confirm that this was the case for Square or Nelnet.

[10] Note that this suggests that Square did not have these individuals hired at the time of the FDIC’s approval.

[11] See prior comments regarding the Square approval.

[12] The final rule specifically noted that the FDIC determined the final rule is an appropriate response to safety and soundness issues surrounding financial and commercial ownership of ILCs under existing law.