CUNA Regulatory Comment Call
April 27, 2004
FASB Request for Information Regarding Loan Participations
EXECUTIVE SUMMARY
- The Financial Accounting Standards Board (FASB) is in the process of amending FASB Statement (FAS) No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This project could potentially significantly change the accounting treatment of loan participations. Generally, credit unions and other financial institutions currently treat a loan participation like a sale. This accounting treatment transfers part of the loan off the selling credit union’s books and onto the purchasing credit unions books.
- FAS 140 establishes the requirements that a transfer must meet in order to be considered a sale for financial reporting purposes. One requirement is that the transferred asset must be isolated from (beyond the reach of) the transferor and its creditors, even in bankruptcy or receivership. FASB is considering disallowing sales treatment for loan participations marked by rights of setoff (the common- law right of debtors and creditors to set off – that is, net – amounts due to one another if one of the parties defaults, becomes insolvent, or enters into bankruptcy or receivership.) In February 2004, FASB tentatively decided that because of a right of setoff in a receivership and because the second institution must stand in line for funds with other creditors of the originating institution, the participating institution is not “isolated” from the originating institution. Under that analysis, FASB reached the conclusion that loan participations marked by rights of setoff are not sales.
- This means that financial institutions would have to use the less advantageous accounting treatment of keeping the assets on the books as secured borrowing. As a result, this project would particularly impact those credit unions involved in loan participations approaching the member business loan cap. Further, the project would impact the capital ratio computation for those credit unions that would have to treat loan participation transactions as secured borrowing.
- The identification of setoff rights as one factor affecting isolation that may not be adequately considered in current practice has led to a concern among the FASB Board members that there may be other unidentified legal factors or conditions that financial institutions and their auditors should consider in reaching conclusions about isolation of transferred assets. Therefore, FASB staff prepared a Request for Information seeking information about setoff rights as well as any other factors or conditions affecting isolation of transferred assets that the Board may not be aware of.
- FASB is particularly interested in hearing from attorneys on the issue of isolation of transferred assets in the context of loan participations. FASB also welcomes feedback from accountants.
- Comments are due to FASB by May 10, 2004. Please send your comments to CUNA by May 5, 2003. Please feel free to fax your responses to CUNA at 202-638-7052; e-mail them to Associate General Counsel Mary Dunn at mdunn@cuna.com or to Senior Regulatory Counsel Catherine Orr at corr@cuna.com; or mail them to Mary or Catherine in c/o CUNA's Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, 6th Floor - South Building, Washington, DC 20004.
- You may obtain a copy of the FASB Request for Information by contacting us or by going to the following Internet address: http://www.fasb.org/project/staff_document_amendst140.pdf
DESCRIPTION OF THE REQUEST FOR INFORMATION
- In practice, auditors base their conclusion about whether transferred assets are isolated from the transferor on whether the transfer would be deemed a true sale at law. If necessary, institutions or their auditors obtain “true sale” opinions from attorneys to support their conclusions based on isolation. Recently, the FASB Board and its staff learned that true sale analyses may not have considered whether there are rights of setoff between the originator of the asset (the transferor) and the original debtor that could have a future effect on the value of the transferred asset to the transferee.
- Under common law, the right of setoff exists between two parties with mutual debtor-creditor relationships (two parties that owe each other). The right of setoff is exercisable by either party in the event of default, insolvency, bankruptcy, or receivership of the other party. Setoff eliminates the smaller balance (the amount payable or the amount receivable), and unless the two are exactly equal, a net difference (payable or receivable) remains outstanding. If one of the parties transfers all or a portion of its financial assets (the amount receivable from the other party) to a third party, the right of setoff between the first two parties may not be eliminated. In other words, the original debtor- creditor relationship may continue to exist for setoff purposes in spite of the transfer. Because the setoff rights are not eliminated by the transfer, the transferred financial asset is not isolated from the transferor as required by FAS 140.
- A loan participation between two banks is one type of arrangement in which the right of setoff has been cited as a potentially significant factor in meeting the isolation requirement in FAS 140. FASB provides the case of a single customer with both a loan payable to the bank and a deposit in that same bank. The originating bank enters into a participation agreement with a second bank for 50 percent of the loan. Traditionally, the originating bank has accounted for the loan participation as a sale of 50 percent of the loan. Iif the originating bank enters receivership, both the receiver (such as the Federal Deposit Insurance Corporation, or FDIC) and customer have the right to set off the bank’s loan receivable from the customer against the customer’s deposit receivable from the bank, even if the deposit is made subsequent to the participation agreement. The amount of the loan eligible to be set off is based on 100 percent of the loan balance and not just the 50 percent that the originating bank continues to account for after entering into the participation agreement.
- In the example, courts have ruled that the customer has fulfilled their obligation for the setoff portion of the loan but continues to be liable under the original loan terms for any net loan balance remaining after setoff if the customer’s deposit receivable from the originating bank is less than the originating bank’s loan receivable from the customer. Further, the participating bank is not entitled to receive a payment as a result of setoff. To the extent a loan that has been subject to a participation is eliminated by setoff against the customer’s deposit in the originating bank, the participating bank has only an unsecured general claim against the originating bank and no claim against the customer.
- It is CUNA’s understanding that credit unions are different from banks in that credit union members have an equity interest in the credit union. A depositor in a bank is a creditor and stands in line with general creditors in the event of a bank liquidation. In contrast, members are not creditors of the credit union, so they stand in line behind other creditors in the event of a credit union liquidation. In other words, the common law right of setoff does not apply in the case of credit unions because there is no mutuality – share accounts establish an ownership relationship, not a creditor-debtor relationship.
- The FASB Board is interested in learning whether there are ways to eliminate setoff rights in a
manner that would satisfy the isolation requirement of FAS 140. Constituents have suggested a number of
techniques for eliminating the right of setoff, in order to achieve isolation for a transfer of financial
assets. Some of the suggested techniques include:
- Transfer of whole assets to a third party without any form of recourse;
- Transfer of whole assets to a bankruptcy-remote special purpose entity (SPE) (in which the transferor holds the equity investment) or a qualifying SPE;
- Explicit waiver of setoff rights by the original debtor;
- Explicit waiver of setoff rights by both the original debtor and the transferor;
- Explicit contractual provision that the contract can be sold to a third party;
- Notification to the original debtor that the transferor has sold the debt to a third party; and
- The transfer is documented in an assignment agreement that includes approval by the debtor.
QUESTIONS
Yes ______ No ______
If not, what are the inaccuracies?
a. Does a setoff right exist between the original debtor and the transferee?
b. Do setoff rights exist if an affiliate of the transferor has a liability to the obligor?
Yes ______ No ______
If so, how can the elimination be accomplished?
Yes ______ No ______
If not, what are the differences?
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Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com Mary Mitchell Dunn • SVP & Associate General Counsel • (202) 508-6736 • mdunn@cuna.com Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 • corr@cuna.com |
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