CUNA Regulatory Comment Call

August 8, 2008

Prompt Corrective Action: Amended Definition of Post-Merger Net Worth

EXECUTIVE SUMMARY

Please feel free to fax your responses to CUNA at 202-638-7052; e-mail them to Senior Vice President and Deputy General Counsel Mary Dunn at mdunn@cuna.coop and to Regulatory Research Counsel Luke Martone at lmartone@cuna.coop; or mail them to Mary and Luke in c/o CUNA’s Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, South Building, Suite 600, Washington, DC 20004-2601. You may also contact us at 800-356-9655, ext. 6732, if you have questions or would like a copy of the proposed rule. A copy of the proposed rule can be accessed here.

BACKGROUND

Natural Person Credit Unions

Prompt Corrective Action

The Credit Union Membership Access Act (CUMAA) of 1998 amended the Federal Credit Union Act to require certain regulatory capital standards called “prompt corrective action” (PCA). PCA established capital standards for federally insured credit unions and corresponding remedies to improve the net worth of credit unions not meeting those standards. The CUMAA “expressly limits a credit union’s net worth to the retained earnings balance of the credit union, as determined under generally accepted accounting principles (GAAP).”

Financial Reporting of Mergers Between Mutual Enterprises

At the time CUMAA mandated PCA, the predominant practice for financial reporting of a natural person or corporate credit union merger was the “pooling method.” This method required an acquiring credit union to combine with its own financial statement components the like components of the merging credit union. This allowed an acquiring credit union to combine its own retained earnings with that of the merging credit union for purposes of measuring the acquirer’s post-merger net worth ratio. The “pooling method” encouraged merging since it would result in an increase in the acquirer’s post-merger net worth.

In 2001, the Financial Accounting Standards Board (FASB) established a new GAAP for business combinations, other than those between mutual enterprises, with its Financial Accounting Statement No. 141. FAS 141 replaced the “pooling method” with the “purchase method,” effective June of 2001. For mergers between mutual enterprises (mutual combinations), such as credit unions, application of FAS 141 has been deferred until the end of 2008. Until then, the “pooling method” will continue to be utilized for such mutual combinations.

In December of 2007, FASB decided that its revised method of financial reporting for business combinations should apply equally to mutual and other combinations. Thus, FAS 141(R) was established and will apply to mutual combinations occurring after December 15, 2008. FAS 141(R) will require the “purchase method” (renamed the “acquisition method”) to be used for credit union mergers. Use of the “acquisition method” will result in the exclusion of a merging credit union’s retained earnings from the post-merger net worth of its acquirer.

Acquisition versus Pooling Method of Financial Reporting

The “acquisition method” would require the fair value of the net assets of a credit union acquired in a merger to be classified as a direct addition to the acquirer’s equity, not as additional retained earnings. Under the Federal Credit Union Act, only retained earnings, and not other forms of equity (e.g. “capital surplus”) would contribute to a credit union’s “net worth.” An acquirer’s post-merger net worth may therefore decrease by use of the “acquisition method” because under this method only the acquiring credit union’s net worth would count for regulatory net worth purposes. This would be because the “acquisition method” counts the acquired credit union’s net worth as non-retained earnings equity, which is not “net worth” within the meaning of the Federal Credit Union Act. A decline in net worth would likely discourage credit unions from merging.

Statutory Expansion of Net Worth Definition

In 2006, Congress enacted the Financial Services Regulatory Relief Act (2006 Relief Act) in hopes of alleviating any negative ramifications on credit union mergers resulting from FAS 141(R). A provision of the 2006 Relief Act expanded the original PCA definition of a natural person credit union’s “net worth” to include “any amounts that were previously retained earnings of any other credit union with which [it] has combined. The express purpose of [this provision from the 2006 Relief Act] is to allow the acquiring credit union ‘to follow the new FASB rule while still allowing the capital of both credit unions to flow forward as regulatory capital and thus preserve the incentive for desirable credit union mergers.’”

Corporate Credit Unions

While corporate credit unions are exempt from PCA, they must still meet a minimum “capital ratio” of 4% and are required to calculate their “retained earnings ratio” on a monthly basis. Similar to PCA, if a corporate credit union’s “capital ratio” falls below 4% it is subject to certain remedies. A corporate credit union’s “retained earnings ratio” is determined by dividing its retained earnings by its moving daily average net assets. A credit union becomes subject to an earnings retention requirement if its retained earnings ratio drops below 2%.

BRIEF DESCRIPTION OF THE PROPOSED RULE

I. Natural Person Credit Union’s Post-Merger Net Worth (Part 702)

The proposed rule would amend the definition of post-merger net worth. The PCA definitions under Part 702 contain the current definition of post-merger net worth. The proposed rule would add to the current definition the following:

(3) For a credit union that acquires another credit union in a mutual combination, net worth also includes the retained earnings of the acquired credit union, or of an integrated set of activities and assets, at the point of acquisition. A mutual combination is a transaction in which a credit union acquires either another credit union, or an integrated set of activities and assets that is capable of being conducted and managed as a credit union for the purpose of providing a return in the form of economic benefits directly to owner members.

The first sentence of proposed section (3) adds to an acquiring credit union’s net worth an amount equal to the merging credit union’s retained earnings balance—yielding a capital measure that approximates the net worth previously obtained from the “pooling method.” It is noted that the “result approximates, but does not duplicate, that of the ‘pooling method’ because CUMAA does not authorize a corresponding exclusion of intangibles from the ‘total assets’ denominator of the net worth ratio.”

Additionally, according to the definition of “mutual combination,” subsection (3) can apply to transactions that convey substantially all of the components of a credit union, even though the components together no longer legally constitute a credit union.

The changes to Part 702 will require application of FAS 141(R) to natural person credit union mergers for financial reporting purposes. These changes will also result in replication of the post-merger net worth obtained under the “pooling method” for PCA purposes.

II. Corporate Credit Union’s Post-Merger Capital (Part 704)

The proposed rule would modify Part 704 to expand the definitions associated with corporate credit union capital to correspond with the statutory expansion of net worth for natural person credit unions. Thus, “capital” would be modified to include “the retained earnings of the acquired credit union, or of an integrated set of activities and assets, at the point of acquisition.”

In order to more closely approximate the capital result of the “pooling method,” the proposal would exclude identifiable (i.e. unserved portions of a field of membership) and unidentifiable intangibles (i.e. goodwill) from the definition of a corporate credit union’s “moving daily average net assets” (MDANA)—the denominator of the capital ratio. Excluding intangibles from the MDANA denominator is intended to approximate the denominator of the capital ratio under the “pooling method.”

The proposed changes to Part 704 will result in applying FAS 141(R) to financial reporting of corporate credit union mergers while replicating the post-merger capital, capital ratio, and retained earnings that would have resulted under the “pooling method.”

QUESTIONS TO CONSIDER REGARDING THE PROPOSED RULE TO AMEND THE DEFINITION OF POST-MERGER NET WORTH

  1. Will the proposed changes to Part 702 actually result in post-merger net worth similar to that obtained under the “pooling method”?
















  2. Are there any alternatives that will result in post-merger net worth more in line with that obtained under the “pooling method”?
















  3. Does use of the “acquisition method” for determining an acquiring credit union’s net worth in fact stifle credit union mergers?
















  4. Even though the statutory definition of net worth does not permit natural person credit unions to exclude intangibles, allowing corporate credit unions to do so approximates for regulatory capital purpose the result that would have been achieved under the “pooling method.” Will this approach adequately address the risk of devaluation and possible loss to the National Credit Union Share Insurance Fund?
















  5. Other comments regarding this proposal or other PCA related concerns.
















    Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com
    Mary Mitchell Dunn • SVP & Deputy General Counsel • (202) 508-6736 • mdunn@cuna.com
    Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com
    Lilly Thomas • Assistant General Counsel • (202) 508-6733 • lthomas@cuna.com
    Luke Martone • Senior Regulatory Counsel • (202) 508-6743 • lmartone@cuna.com