Is Subordinated Debt Worth the Hassle?  

The NCUA’s long and increasingly tortured history with subordinated debt took another turn last week, albeit not a particularly large one, when it finalized more changes to its subordinated debt rule. Most importantly, eligible credit unions can now offer subordinated debt with maturities greater than 20 years.

Since the NCUA authorized low-income credit unions to issue unsecured capital to non-members in 1996, the NCUA’s opinion of secondary capital has vasalated between considering it an important tool to help low-income credit unions meet the needs of their members, and a misused regulatory perk best understood as a security. Over the last six years in particular, there has been a decisive shift on both a policy and legal level, making it more difficult for low-income credit unions to qualify for subordinated debt while, at the same time, greatly expanding its availability for larger credit unions. The NCUA has got it half right, and now it’s up to the industry to continue to debate and advocate for expanded access to alternative capital.

First, let me explain how I’m going to be using some terms. By a “security,” I am referring to a note that would be classified as a security under the Securities and Exchange Act of 1933. Within this context, whether we are referring to “secondary capital” or “subordinated debt,” what we are talking about is a loan in which the issuing credit union can use the proceeds to help fund capital needs in return for paying back the loan with interest over time. The debt must be subordinate to all other claims that can be made against the credit union.

Second, over the decades, this debt has been characterized as “supplemental capital,” “secondary capital” and, most recently, “subordinated debt.” While there have historically been distinctions between this type of debt, I will generally be using “subordinated debt” as a catch-all phrase. Third, under existing regulations, new credit unions, which meet certain requirements, complex credit unions and low-income credit unions are eligible to apply for subordinated debt, but must receive the approval of the NCUA. Complex credit unions can only use subordinated debt to satisfy the enhanced capital requirements for credit unions with $500 million or more in assets.

Nothing exemplifies the NCUA’s misgivings about the proper role of subordinated debt more than its struggles over the last six years to determine whether secondary capital/supplemental capital should, in fact, be considered a security. In 2017, the NCUA issued an Advanced Notice of Proposed Rulemaking in which it opined in the preamble that any subordinated debt would be deemed a security for purposes of federal and state law. The NCUA finalized these regulations in 2020 with a requirement that such notes can only be offered to “accredited investors” and have maturities no greater than 20 years.

Categorizing subordinated debt as a security was one of the most important reversals of a long standing agency legal interpretation in at least the last 20 years. By opining for the first time that subordinated debt was subject to federal securities law, the NCUA was imposing increased direct and indirect costs on credit unions, which may make it cost-prohibitive for low-income and new credit unions to issue subordinated debt.

As federal securities, subordinated debt issued by credit unions are subject to enhanced disclosure requirements and offering documents for which they need the assistance of a “qualified” securities counsel. The bottom line is that a tool originally intended as a straightforward way for low-income credit unions to meet capital needs while extending services to low-income communities has become an increasingly complicated, cost-prohibitive, legal exercise for which only larger, complex credit unions seem equipped.

What makes the NCUA’s monumental decision to recharacterize secondary capital as a security somewhat perplexing is that there was no external regulatory statutory change or legal decision that forced the NCUA to reevaluate its previous implicit conclusion that secondary capital was not subject to the securities law. In fact, the most significant decision outlining the framework to be used for determining when a note could be considered a security was issued by the Supreme Court in 1990 in the case Reves v. Ernst & Young. I’m hoping that stakeholders and the NCUA’s legal department are looking for creative ways to minimize the cost and complexity of the designation.

Despite these legal developments, let’s assume that your credit union has examined the legal complexities and still believes that subordinated debt is the right tool for your institution. A history lesson also underscores how ambivalent the NCUA has been when it comes to the safety and soundness concerns accompanying subordinated debt.

Whereas in 1996, low-income credit unions did not even have to get the NCUA’s approval to issue debt. By 2006, the NCUA issued a regulation mandating that credit unions only issue subordinated debt with the approval of regional directors following the submission of a plan for how that capital was going to be used.

In the preamble to the 2006 rule, the NCUA sounded like it was writing a letter on behalf of the American Bankers Association. It accused credit unions with subordinated debt of: “(1) Poor due diligence and strategic planning in connection with establishing and expanding member service programs such as ATMs, share drafts and lending (e.g., member business loans or MBLs, real estate and subprime); (2) Failure to adequately perform a prospective cost/benefit analysis of these programs to assess such factors as market demand and economies of scale; (3) Premature and excessively ambitious concentrations of USC to support unproven or poorly performing programs; and (4) Failure to realistically assess and timely curtail programs that, in the face of mounting losses, are not meeting expectations. When they occur, these lenient practices contribute to excessive net operating costs, high losses from loan defaults and a shortfall in revenues (due to non-performing loans and poorly performing programs) — all of which, in turn, produce lower than expected returns.”

Fast forward to the 2010s and credit unions were being encouraged to become designated as low-income in part so that they could acquire subordinated debt. Fast forward again to 2019, and the NCUA had once again taken a decisive shift back to viewing subordinated debt as a potentially dangerous tool on which there needed to be strict parameters.

In a 2019 guidance a credit union had to: State the maximum aggregate amount of uninsured capital it plans to issue; identify the purpose for which the capital will be used and how it will be repaid; explain how it will provide for liquidity to repay the secondary capital upon maturity and demonstrate that the planned uses of the capital conform to the credit union’s strategic plan and pro forma financial statements. These requirements were incorporated and expanded upon in the final subordinated debt regulations, although credit unions can now provide cash flow projections as opposed to a statement of cash flows because of last week’s amendments.

All of these criteria emphasize safety and soundness, giving a tremendous amount of responsibility and discretion to examiners and credit unions to develop, implement and monitor the uses of subordinated debt. From a safety and soundness standpoint this is, of course, defensible, but it also further complicates the ability of low income credit unions to qualify for subordinated debt.

Where does all this leave us? My concern is that there is as much need for low-income credit unions to access additional forms of capital today as there was in 1996. In contrast, as presently constituted, subordinated debt will, on a practical level, be available almost exclusively to the largest credit unions. This is an awfully big shift in credit union policy for which I think there should have been and still needs to be much more debate and consideration within the industry. From a safety and soundness standpoint, the industry might be marginally better off, but I’m afraid that this has come at the expense of helping credit unions provide services to people of modest means.

Henry Meier is the former General Counsel of the New York Credit Union Association, where he authored the popular New York State of Mind blog. He now provides legal advice to credit unions on a broad range of legal, regulatory and legislative issues. He can be reached at (518) 223-5126 or via email at henrymeieresq@outlook.com.