Over the past couple of months, the COVID-19 outbreak has wreaked havoc on the United States economy, sparing almost no industry, business, or individual person. In response, lenders have generously granted loan concessions, and the federal government has adopted multiple trillions of dollars in relief funding, the most significant of which being the Paycheck Protection Program, or “PPP,” as it has become known. That these efforts have buoyed businesses and individuals alike is without question. What remains to be seen, however, is whether and to what extent they will remain afloat once these relief measures expire. Most loan deferrals were for 90 to 120 days, and will begin reverting back to regular payments sometime this summer. And borrowers’ eight weeks of PPP loan proceeds will mostly be used up by June 30. It is inevitable that, eventually, loan delinquencies will begin to rise, and banks will be faced with the prospect of how best to manage a growing number of problem loans. One technique for mitigating the impact of problem loans on the bank’s balance sheet is to transfer them to a liquidating subsidiary.
Liquidating subsidiaries—sometimes referred to as the “good bank/bad bank” model—have been around for years. They were widely employed in the wake of the 2008 Financial Crisis by the largest financial institutions and community banks alike. In its simplest terms, a liquidating subsidiary is merely an operating subsidiary of a bank holding company created for the specific purpose of purchasing problem assets (e.g., delinquent loans, OREO, repossessed assets, etc.) from its sister bank.
Liquidating subsidiaries are most beneficial in times of economic distress, such as has been caused by the COVID-19 outbreak, when delinquencies, foreclosures, repossessions, and bankruptcies tend to intensify. Selling problem assets to a liquidating subsidiary relieves pressure on the bank’s capital, enabling the bank to deploy any excess capital on growth-oriented business activities, rather than as a buffer against potential loan losses. It also improves the bank’s asset quality metrics for reporting purposes, resulting in less scrutiny from examiners come exam time. A healthier balance sheet also strengthens depositor confidence in the financial stability of the bank. For banks whose parent bank holding companies have outstanding bank stock loans, removing problem assets from the balance sheet may also enable the holding company to satisfy certain financial covenants contained in the loan documents where it otherwise might not have been able to do so. Importantly, because a liquidating subsidiary is not subject to examinations like the bank, it allows for greater flexibility in the management, workout, collection, and disposal of problem assets, which generally results in reduced loan losses. It also largely discharges bank management from the arduous task of performing and/or overseeing these activities.
The process for establishing a liquidating subsidiary is relatively simple. First, the holding company establishes a subsidiary—likely a corporation or limited liability company—and capitalizes it with an equity contribution. Then within 10 days thereafter, the holding company submits a notice to the appropriate Federal Reserve Bank of its intent, through an operating subsidiary, to purchase, service, collect and liquidate problem assets from the bank. Being a notice filing (as opposed to a formal application), the proposed activity does not require Federal Reserve approval as long as it falls within one of the exempted non-banking activities permissible of a bank holding company under Regulation Y. Among other items, the notice must describe the liquidation plan for timely disposing of any OREO within the applicable holding period.
The liquidating subsidiary’s purchase of loans or other assets from its sister bank would be considered a transaction with an affiliate and governed by Section 23B of the Federal Reserve Act and corresponding Federal Reserve Regulation W. All such purchases must be on “market terms,” meaning “on terms and under circumstances . . . that are substantially the same, or at least as favorable to the [bank], as those prevailing at the time for comparable transactions with nonaffiliates.” Generally, if the bank has properly accounted for a loan or other asset under generally applicable accounting principles (GAAP), a sale of the asset to the liquidating subsidiary at book value will satisfy the market terms requirement of Regulation W. Loans or other assets sold for less than book value would likely draw scrutiny from examiners.
Other relevant considerations include the following:
- Another source of funding for the liquidating subsidiary could be a loan secured by the liquidating subsidiary’s loan portfolio and other assets.
- The OREO holding period limitation applicable to the bank also applies to the liquidating subsidiary, and does not reset upon transfer of the OREO to the liquidating subsidiary. Generally, the holding period for OREO held in a liquidating subsidiary is two years, with the possibility of three one-year extensions if approved by the Federal Reserve.
- If the activities of the liquidating subsidiary are going to be conducted by an employee of the bank, the bank and liquidating subsidiary will need to enter into a shared services agreement providing for the allocation of employee time, reimbursement of salary and other expenses, as well as other factors pertinent to the relationship between the parties.
Though ideally one would like to avoid the necessity of considering the efficacy of a liquidating subsidiary, they do serve a meaningful purpose under circumstances of deterioration of the bank’s loan portfolio. For additional information or any questions regarding liquidating subsidiaries, please contact Bruce Toppin by e-mail at [email protected] or by telephone at (210) 253-7102.