Subordinated Debt

Federal RegisterMar 10, 2020

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NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 701, 702, 709, and 741

RIN 3133-AF08

Subordinated Debt

AGENCY:

National Credit Union Administration (NCUA).

ACTION:

Proposed rule.

SUMMARY:

The NCUA Board (Board) is proposing to amend various parts of the NCUA's regulations to permit low-income designated credit unions (LICUs), Complex Credit Unions, and New Credit Unions to issue Subordinated Debt for purposes of regulatory capital treatment. Specifically, this proposed rule would create a new subpart in the NCUA's final risk-based capital rule (RBC Rule) that would address the requirements for and regulatory capital treatment of Subordinated Debt. This new subpart would, among other things, contain requirements related to applying for authority to issue Subordinated Debt, credit union eligibility to issue Subordinated Debt, prepayments, disclosures, securities laws, and the terms of a Subordinated Debt Note. This proposed rule also makes various additions and amendments to other parts and sections of the NCUA's regulations.

DATES:

Comments must be received on or before July 8, 2020.

ADDRESSES:

You may submit written comments, identified by RIN 3133-AF08, by any of the following methods (Please send comments by one method only):

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

•

Fax:

(703) 518-6319. Include “[Your Name]—Comments on Proposed Rule: Subordinated Debt” in the transmittal.

•

Mail:

Address to Gerard Poliquin, Secretary of the Board, National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428.

•

Hand Delivery/Courier:

Same as mail address.

Public Inspection:

You may view all public comments on the Federal eRulemaking Portal at

http://www.regulations.gov,

as submitted, except for those we cannot post for technical reasons. The NCUA will not edit or remove any identifying or contact information from the public comments submitted. You may inspect paper copies of comments in the NCUA's law library at 1775 Duke Street, Alexandria, Virginia 22314, by appointment weekdays between 9 a.m. and 3 p.m. To make an appointment, call (703) 518-6546 or email

OGCMail@ncua.gov.

FOR FURTHER INFORMATION CONTACT:

Tom Fay, Director of Capital Markets; or Justin M. Anderson, Senior Staff Attorney, Office of General Counsel, 1775 Duke Street, Alexandria, VA 22314-3428. Tom Fay can also be reached at (703) 518-1179, and Justin Anderson can be reached at (703) 518-6540.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background

A. History

B. Legal Authority

C. Credit Union Data

D. Summary of the Proposed Rule

E. Securities Law Issues

II. Proposed Changes

A. Part 701—Organization and Operations of Federal Credit Unions

B. Part 702—Capital Adequacy

C. Subpart D—Subordinated Debt, Grandfathered Secondary Capital, and Regulatory Capital

D. Part 709—Involuntary Liquidation of Federal Credit Unions and Adjudication of Creditor Claims Involving Federally Insured Credit Unions in Liquidation

E. Part 741—Requirements for Insurance

III. Regulatory Procedures

A. Paperwork Reduction Act

B. Executive Order 13132

C. Assessment of Federal Regulations and Policies on Families

Part 701—Organization and Operations of Federal Credit Unions

§ 701.25 Loans to Credit Unions

§ 701.34 Designation of Low Income Status

§ 701.38 Borrowed Funds

Part 702—Capital Adequacy

§ 702.2 Definitions

§ 702.104 Risk-Based Capital Ratio

§ 702.109 Prompt Corrective Action for Critically Undercapitalized Credit Unions

§ 702.205 Prompt Corrective Action for Uncapitalized New Credit Unions

§ 702.206 Revised Business Plans (RBP) for New Credit Unions

§ 702.207 Consideration of Subordinated Debt and Grandfathered Secondary Capital for New Credit Unions

Subpart D—Subordinated Debt, Grandfathered Secondary Capital, and Regulatory Capital

§ 702.401 Purpose and Scope

§ 702.402 Definitions

§ 702.403 Eligibility

§ 702.404 Requirements of the Subordinated Debt and Subordinated Debt Note

§ 702.405 Disclosures

§ 702.406 Requirements Related to the Offer, Sale, and Issuance of Subordinated Debt Notes

§ 702.407 Discounting of Amount Treated as Regulatory Capital

§ 702.408 Preapproval To Issue Subordinated Debt

§ 702.409 Preapproval for Federally Insured, State-Chartered Credit Unions To Issue Subordinated Debt

§ 702.410 Interest Payments on Subordinated Debt

§ 702.411 Prior Written Approval To Prepay Subordinated Debt

§ 702.412 Effect of a Merger or Dissolution on the Treatment of Subordinated Debt as Regulatory Capital

§ 702.413 Repudiation Safe Harbor

§ 702.414 Regulations Governing Grandfathered Secondary Capital

Part 709—Involuntary Liquidation of Federal Credit Unions and Adjudication of Creditor Claims Involving Federally Insured Credit Unions in Liquidation

§ 709.5 Payout Priorities in Involuntary Liquidation

Part 741—Requirements of Insurance

§ 741.204 Maximum Public Unit and Nonmember Accounts, and Low-Income Designation

§ 741.226 Subordinated Debt

§ 741.227 Loans to Credit Unions

I. Background

A. History

1. Secondary Capital for LICUs

In 1996, the Board finalized § 701.34 of the NCUA's regulations to permit LICUs to raise secondary capital from foundations and other philanthropic-minded non-natural person members and non-members.

The Board issued the rule to provide an additional way for a LICU to build regulatory capital in order to serve two specific purposes: (1) Support greater lending and financial services in the communities served by the LICU; and (2) absorb losses to prevent the LICU from failing.

See

61 FR 50696 (Sept. 27, 1996) (final rule); see also 61 FR 3788 (Feb. 2, 1996) (interim final rule); 12 CFR 701.34.

In 1998, as part of the Credit Union Membership Access Act (CUMAA),

Congress amended the Federal Credit Union Act (the Act) to institute a system of prompt corrective action for federally insured credit unions based on a credit union's level of net worth. Relevant to this proposed rule, CUMAA specifically defined “net worth,” among other things, to include secondary capital issued by a LICU provided that the secondary capital be uninsured and subordinate to all other claims against the LICU, including the claims of creditors, shareholders, and the National Credit Union Share Insurance Fund (NCUSIF).

Credit Union Membership Access Act of 1998,

Public Law 105-219, 301, 112 Stat. 913, 929 (codified at 12 U.S.C. 1790d(o)(2)(C) (1998)).

Id.

In 2006, the Board further amended § 701.34 to require regulatory approval of a LICU's secondary capital plan before the LICU could issue secondary capital.

In the preamble to the final 2006 rule, the Board noted that LICUs had sometimes used secondary capital to achieve goals different from those for which it was originally intended. It also highlighted a pattern of “lenient practices” by LICUs issuing secondary capital, which contributed to excessive net operating costs, high losses from loan defaults, and a shortfall in revenue.

The Board stated:

71 FR 4234 (Jan. 26, 2006).

Id.

at 4236. Before 2006, a LICU was required to submit a copy of its secondary capital plan to the NCUA, but it was not required to obtain preapproval.

These practices include: (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 (“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 [Uninsured Secondary Capital] 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.

Id.

at 4236-37.

The Board also stated:

Promoting diligent practices in place of lenient ones cannot help but improve the safety and soundness of LICUs. Requiring prior approval of [an Uninsured Secondary Capital] Plan will strengthen supervisory oversight and detection of lenient practices in several ways. First, it will prevent LICUs from accepting and using [Uninsured Secondary Capital] for purposes and in amounts that are improper or unsound. Second, the approval requirement will ensure that [Uninsured Secondary Capital] Plans are evaluated and critiqued by the Region before being implemented. Third, for both the NCUA and the LICU, an approved [Uninsured Secondary Capital] Plan will document parameters to guide the proper implementation of [Uninsured Secondary Capital], and to measure the LICU's progress and performance.

Id.

at 4237.

The Current Secondary Capital Rule

provides that secondary capital accounts must:

12 CFR 701.34. The last substantive amendment to the NCUA's secondary capital rule were in 2010 with the addition of language regarding secondary capital received under the Community Development Capital Initiative of 2010. 75 FR 57843 (Sept. 23, 2010).

• Be established as an uninsured secondary capital account or another form of non-share account;

• Have a minimum maturity of five years;

• Not be insured by the NCUSIF or any governmental or private entity;

• Be subordinate to all other claims against the LICU, including those of shareholders, creditors, and the NCUSIF;

• Be available to cover losses that exceed the LICU's net available reserves and, to the extent funds are so used, a LICU may not restore or replenish the account under any circumstances.

Further, losses must be distributed

pro rata

among all secondary capital accounts held by the LICU at the time the loss is realized;

This generally means that when net operating losses exceed Retained Earnings, a LICU needs to first use the secondary capital funds to cover the excess amount.

• Not be pledged or provided by the investor as security on a loan or other obligation with the LICU or any other party;

• Be evidenced by a contract agreement between the investor and the LICU that reflects the terms and conditions mandated by the Current Secondary Capital Rule and any other terms and conditions not inconsistent with that rule;

• Be accompanied by a disclosure and acknowledgment form as set forth in the appendix to the Current Secondary Capital Rule;

• Not be repaid, including any interest or dividends earned thereon, if the Board has prohibited repayment thereof under §§ 702.204(b)(11), 702.304(b), or 702.305(b) of the NCUA's regulations because the LICU is classified as “Critically Undercapitalized”; or, if a LICU is a New Credit Union (as defined under § 702.2 of the NCUA's regulations), as “Moderately Capitalized,” “Marginally Capitalized,” “Minimally Capitalized,” or “Uncapitalized;”

• Be recorded on the LICU's balance sheet;

While the Current Secondary Capital Rule requires a LICU to record secondary capital accounts on its balance sheet as “equity accounts,” generally accepted accounting principles in the United States require secondary capital accounts to generally be recorded as “debt.”

See

FASB (Financial Accounting Standards Board), ASC 942-405-25-3 and 25-4. The instructions to the 5300 Call Report require all federally insured credit unions to report any secondary capital in the Liability section of the Statement of Financial Condition.

• Be recognized as net worth in accordance with the schedule for recognizing net worth value in subsection (c)(2) of the Current Secondary Capital Rule;

• Be closed and paid out to the account investor in the event of a merger or other voluntary dissolution of a LICU, to the extent the secondary capital is not needed to cover losses at the time of the merger or dissolution (does not apply in the case where a LICU merges into another LICU); and

• Only be repaid at maturity,

except that, with the prior approval of the NCUA and provided the terms of the account allow for early repayment, a LICU may repay any portion of secondary capital that is not recognized as net worth.

A LICU may not issue a secondary capital account that amortizes over its stated term.

See

12 CFR 701.34(d).

The Current Secondary Capital Rule also includes requirements related to secondary capital plan submissions and approvals, redemption of secondary capital, disclosures, and regulatory capital treatment.

As noted above, since the passage of the CUMAA, a LICU that issues secondary capital is permitted to include the aggregate outstanding principal amount of that secondary capital in its Net Worth. Further, pursuant to the NCUA's currently effective risk-based net worth requirements, a LICU is also permitted to include such secondary capital in its risk-based net worth calculation. By contrast, a non-LICU lacks the authority to issue secondary capital and, to the extent it issues any instruments analogous to secondary capital, to include any such instruments in either its Net Worth or its risk-based net worth calculation.

In October 2015, the Board finalized a rule to replace the current risk-based net worth requirement with a risk-based capital (RBC) requirement.

Under this revised standard, a LICU will be permitted to include secondary capital in its RBC calculations in the same fashion as it currently includes secondary capital in its risk-based net worth calculation. With this proposed rule, the Board now proposes to grant certain non-LICUs the authority to issue instruments in the form of subordinated debt and allow those instruments to be counted in their respective RBC calculations. This new authority,

however, would not permit non-LICUs to include subordinated debt in Net Worth.

80 FR 66626 (Oct. 29, 2015). The Board has twice delayed the effective date for the final RBC Rule. First, in 2018, the effective date was delayed by one year, from January 1, 2019, to January 1, 2020. 83 FR 55467 (Nov. 6, 2018). Second, based on Board action at the December 2019 Board meeting, the effective date has been delayed for an additional two years from January 1, 2020 to January 1, 2022.

As discussed in more detail in the following subsections, under this proposed rule, certain non-LICUs would be permitted to issue Subordinated Debt and include such debt in their RBC calculation. In addition, under this proposed rule, all LICUs would be permitted to issue Subordinated Debt for Regulatory Capital treatment.

Under this proposed rule, an Issuing Credit Union (defined in § 702.402 of the proposed rule) would be subject to the various requirements discussed in this preamble, including, but not limited to, securities laws, which are further discussed in section I. (E) of this preamble.

This proposal would not change the ability of a LICU to include Subordinated Debt in its Net Worth in the same manner in which it currently includes secondary capital in its net worth.

2. Subordinated Debt for LICUs and Certain Non-LICUs

RBC

In the proposed RBC rule issued in 2015,

the Board requested stakeholder input on supplemental capital.

Specifically, the Board posed the following six questions:

80 FR 4340 (Jan. 27, 2015).

Id.

at 4384. The Board notes that when the agency began to consider authorizing non-LICU credit unions to issue instruments analogous to secondary capital instruments issued by LICUs, it used the term “supplemental capital” to refer to those instruments. In 2017, when the Board issued an advance notice of proposed rulemaking on this topic, the NCUA used the umbrella term “alternative capital” to refer to both supplemental capital and secondary capital. In light of FCUs' authority only to issue

debt

instruments, however, the Board believes that it is more appropriate and accurate to use the umbrella term “Subordinated Debt” to refer to both secondary capital and what was once referred to as supplemental capital. It is important to note that, unless the context otherwise requires, the term “Subordinated Debt” refers to BOTH types of debt instruments.

(1) Should additional supplemental forms of capital be included in the RBC [ratio] numerator and how would including such capital protect the NCUSIF from losses?

(2) If yes to be included in the RBC [ratio] numerator, what specific criteria should such additional forms of capital reasonably be required to meet to be consistent with [United States generally accepted accounting practices (U.S. GAAP)] and the [FCU] Act, and why?

(3) If certain forms of certificates of indebtedness were included in the RBC ratio numerator, what specific criteria should such certificates reasonably be required to meet to be consistent with [U.S.] GAAP and the [FCU] Act, and why?

(4) In addition to amending the NCUA's RBC regulations, what additional changes to the NCUA's regulations would be required to count additional supplemental forms of capital in the NCUA's RBC ratio numerator?

(5) For [federally insured,] state-chartered credit unions, what specific examples of supplemental capital currently allowed under state law do commenters believe should be included in the RBC ratio numerator, and why should they be included?

(6) What investor suitability, consumer protection, and disclosure requirements should be put in place related to additional forms of supplemental capital?

Id.

In response to these questions, a majority of the commenters who addressed supplemental capital stated that it was imperative that the Board consider allowing credit unions to issue additional forms of capital. The commenters suggested this authority was particularly important because credit unions are at a disadvantage in the financial marketplace because most lack access to additional capital outside of Retained Earnings.

While none of the commenters offered specific suggestions on how to implement supplemental capital, a few suggested that the Board promulgate broad, non-prescriptive rules to allow credit unions maximum flexibility in issuing supplemental capital.

2017 Advance Notice of Proposed Rulemaking (ANPR)

On February 8, 2017, the Board published an ANPR to solicit comments on alternative forms of capital that credit unions could use in meeting capital standards required by statute and regulation.

In response, the Board received 756 comments.

82 FR 9691 (Feb. 8, 2017).

Of the 756 comments received, 688 appeared to be derived from one form letter.

The form letter opposed the NCUA proceeding with a supplemental capital proposal, reasoning that allowing credit unions to issue supplemental capital would result in credit unions having an ownership structure similar to most tax-paying banks. It also maintained that credit unions have poorly managed existing secondary capital and suggested that, when combined with the necessary compliance with federal and state securities laws, this would result in widespread credit union failures and taxpayer bailouts. In addition, commenters that opposed a supplemental capital proposal generally stated that the FCU Act does not permit credit unions to issue supplemental capital.

While there were slight modifications to some letters, the substance of each letter was the same.

The Board disagrees with these assertions. First, most LICUs that have issued secondary capital generally have managed such capital well. Since the NCUA began requiring LICUs to obtain prior approval before issuing secondary capital, the Board is not aware of material losses to the NCUSIF resulting from the mismanagement of secondary capital. Further, the Board is proposing clear and robust requirements related to securities laws compliance, which will help ensure that Issuing Credit Unions are able to effectively navigate the complex framework of securities laws. Finally, as detailed more fully in section I. (B) of this preamble, section 1757(9) of the FCU Act grants a Federal Credit Union (FCU) the authority to issue debt instruments of the type contemplated by the ANPR and now by this proposed rule.

The authority of a federally insured, state-chartered credit union (FISCU) to issue such instruments is derived from applicable state law.

12 U.S.C. 1757(9).

In addition to the form comment letters, the Board received 68 unique comments in response to the ANPR. Most of those comments supported proposing a rule to allow non-LICUs to issue an alternative form of capital. A majority of the commenters in favor of a proposal cited compliance with the NCUA's RBC Rule as the main reason for their support. Other reasons for support included credit union growth, protection from economic downturns, and providing services demanded by members.

In general, the comments lacked specificity, and very few commenters addressed all or even most of the questions that the Board posed. Nevertheless, they covered a wide range of topics and offered varying levels of support for certain provisions. A discussion of more specific commenter feedback follows. The Board notes that, as demonstrated by the remainder of this preamble, it considered all comments to the ANPR in developing this proposed rule.

Permissible Investors

Commenters opining on permissible investors typically addressed two distinct issues: Membership of investors and classification of investors. Eighteen commenters addressed the membership of investors. More than half of these commenters believed that both members

and non-members should be permitted to invest in supplemental capital, citing both market and flexibility advantages for Issuing Credit Unions. Five commenters believed that restricting investment to members would help preserve the mutual, member-owned structure of credit unions. One commenter argued that only non-members should be permissible investors.

On the topic of investor classification, commenters were split almost evenly between providing maximum flexibility by permitting all persons to purchase supplemental capital and restricting investors to only non-natural persons or accredited investors. Commenters in favor of limiting the classes of potential investors stated that by only permitting more sophisticated investors, it would allow the NCUA's supplemental capital rule to be more flexible with respect to required disclosures.

As discussed in more detail in section II. (C)(4) of this preamble, the Board is proposing to allow credit unions to issue Subordinated Debt to both members and non-members, provided the investor meets the definition of either “Entity Accredited Investor” or “Natural Person Accredited Investor.” These terms are further discussed in sections II. (C)(2) and (4) of this preamble.

Disclosures

Twenty-seven commenters addressed the issue of disclosures. The majority of these commenters urged the NCUA to model any required disclosures after those established by the Office of the Comptroller of the Currency (OCC) or the Securities and Exchange Commission (SEC). These commenters maintained that these disclosures provide the highest level of investor and credit union protection and are the most familiar to investors. As discussed in greater detail in section II. (C)(5) of this preamble, the Board generally modeled the proposed disclosures in this rule after those required by the OCC and SEC.

Registration

Nine commenters that addressed this issue advocated against requiring any form of registration with the NCUA before supplemental capital issuances. These commenters stated that the NCUA should require credit unions to follow SEC rules, which would likely exempt them from registration with the SEC. The commenters further cited flexibility and cost as reasons against registering with the NCUA. In addition, three commenters advocated for registration, citing safety and soundness concerns and comparability with the OCC's rules for national banks and federal savings associations.

While the Board is not proposing a formal registration process similar to that employed by the SEC for securities issuances registered under the Securities Act of 1933, as amended (Securities Act), the proposed rule would require any credit union contemplating an offer or sale of Subordinated Debt Notes (as defined in § 702.402 of the proposed rule) to obtain the NCUA's prior written approval before engaging in that activity. In addition, under this rule, every such offer and sale of Subordinated Debt Notes would require the preparation and delivery of certain offering materials to investors that conform to this rule's requirements and all applicable federal and state securities law (Offering Documents). Depending on whether a potential investor is an Entity Accredited Investor or a Natural Person Accredited Investor (each as defined in section II. (C)(2)), the Issuing Credit Union may need to obtain the NCUA's prior written approval before it uses such offering materials to offer and sell the Subordinated Debt Notes. See II. (C)(4) and (C)(6) of this preamble for detailed discussions about these requirements.

Permissible Instruments

Thirty-four commenters addressed the topic of permissible instruments. Of these commenters, 22 favored a broad, principles-based approach to identifying permissible instruments, believing such an approach would allow credit unions to more easily meet the demands of investors and lower the cost of issuance. These commenters stated that the Board should provide a list of broad qualifications for a capital instrument and that any instrument fitting those qualifications should count as regulatory capital. While commenters did not clearly describe qualifications the Board should impose, some cited Basel III

and the Current Secondary Capital Rule as possible models for the qualifications.

Basel Committee on Banking Supervision, Basel III

: A global regulatory framework for more resilient banks and banking systems.

(2011).

Conversely, the remaining 12 commenters addressing this topic stated that the Board should only permit debt instruments to count as regulatory capital, citing purchasers of debt lack of voting rights, ownership, and influence over credit unions. These commenters argued that limiting the type of instrument to debt was an additional protection against erosion of the mutual structure and potential loss of the credit union tax exemption. Please see the following section in this preamble for a detailed discussion of permissible instruments.

B. Legal Authority

1. Authority To Issue Subordinated Debt

The borrowing authority granted to FCUs by the FCU Act, along with FCUs' statutory authority to enter into contracts and exercise incidental powers necessary or required to enable the FCUs to effectively carry on their business, supports the legal analysis that FCUs are authorized to incur indebtedness through the issuance of debt securities of the type contemplated by this proposed rule. Section 1757(9) of the FCU Act authorizes FCUs:

to borrow, in accordance with such rules and regulations as may be prescribed by the Board, from any source, in an aggregate amount not exceeding, except as authorized by the Board in carrying out the provisions of subchapter III of this chapter, 50 per centum of its paid-in and unimpaired capital and surplus: Provided, That any Federal credit union may discount with or sell to any Federal intermediate credit bank any eligible obligations up to the amount of its paid-in and unimpaired capital.

12 U.S.C. 1757(9).

Other than the provisions of § 701.38 of the NCUA's regulations, which addresses borrowed funds from natural persons, the FCU Act does not provide any details as to the mechanisms that FCUs may employ to borrow.

Further, section 201(b)(7) of the FCU Act implicitly allows credit unions to issue securities.

Conversely, nothing in section 1757(9) or other provisions of the FCU Act appears to impose any specific restrictions or limitations on the mechanisms FCUs may employ to borrow, through the use of specific

limiting language, examples or illustrative transactions or situations, or otherwise. This stands in sharp contrast to many other subsections of section 1757 of the FCU Act which, for example, go into significant detail describing the types and terms of loans and extensions of credit that FCUs are permitted to make,

and define the types of investments FCUs are permitted to make.

In addition, the NCUA's regulations do not impose any specific restrictions or limitations on the mechanisms an FCU may employ to borrow, through the use of specific limiting language, examples, illustrative transactions, or situations.

In contrast, certain provisions of Title 12 of the United States Code relating to the regulation of other types of financial institutions expand on the institutions' basic authority to borrow money, including through the issuance of securities. For example, a Farm Credit System member is specifically authorized to:

(a) Borrow money from or loan to any other institution of the System, borrow from any commercial bank or other lending institution, issue its notes or other evidence of debt on its own individual responsibility and full faith and credit, and invest its excess funds in such sums, at such times, and on such terms and conditions as it may determine.

(b) Issue its own notes, bonds, debentures, or other similar obligations, fully collateralized as provided in section 2154(c) of this title by the notes, mortgages, and security instruments it holds in the performance of its functions under this chapter in such sums, maturities, rates of interest, and terms and conditions of each issue as it may determine with approval of the Farm Credit Administration.

12 U.S.C.2153(a)(b).

Id.

section 1781(b)(7)

Id.

1757(5).

Id.

1757(7); (15).

Overall, the lack of specific restrictions or limitations on the mechanisms that may be employed and the specific authority granted in section 1757(9) to borrow “from any source” indicate that borrowings need not be limited to the types of arrangements typically entered into with banks, other credit unions, and other financial institutions—namely, loans, lines of credit, and similar arrangements. Further, the specific authority provided in section 1757(1) of the FCU Act empowering FCUs to enter into contracts

further supports the conclusion that FCUs have the power to enter into a variety of different arrangements with respect to borrowing.

In addition, in the absence of specific restrictions and limitations, the “incidental powers” granted to FCUs in section 1757(17) of the FCU Act give significant discretion to FCUs with respect to how borrowings are effected.

Id.

1757(1).

Typical loan and line of credit arrangements entered into with banks, other credit unions and other financial institutions are clearly contractual in nature. Debt securities are also generally viewed as primarily contractual in nature, in large measure because of the terms of the securities themselves or the terms incorporated into the securities through an indenture, an issuing and paying agent agreement or similar agreement. This view of debt securities has been expressed in a wide variety of court cases.

See, e.g., Katz

Oak Industries, Inc.,

508 A.2d 873, 878 (Del. Ch. 1986)) (“Under our law—and the law generally—the relationship between a corporation and the holders of its debt securities, even convertible debt securities, is contractual in nature.”).

Further support for the position that FCUs have the authority to issue debt securities may be found in U.S. GAAP treatment of items that fall in the category of “borrowings.” Under U.S. GAAP, liabilities relating to borrowed money are presented as indebtedness on an entity's balance sheet, and the interest paid is presented as interest expense on its income statement, whether the borrowings are related to typical loan transactions, advances under lines of credit, or the issuance of debt securities. While the details of the different types of indebtedness for borrowed money are presented as separate line items in an entity's balance sheet and income statement, the treatment of “straight” indebtedness (indebtedness that does not have equity/residual ownership features, such as convertibility into shares) as liabilities, and interest paid thereon as interest expense, is essentially the same. In addition, while the details of the different types of indebtedness for borrowed money are presented as separate line items in the statement of cash flows, borrowings, whether in the form of loans from financial institutions or from the issuance of debt securities, are all presented in the “cash flows from financing activities” section of the statement.

Throughout this proposed rule, the Board has included requirements to ensure that any Subordinated Debt issued by an Issuing Credit Union would be properly characterized as debt in accordance with U.S. GAAP. These requirements, as discussed in more detail in this preamble, include that the Subordinated Debt or the Subordinated Debt Note, as applicable, must:

• Be in the form of a written, unconditional promise to pay on a specified date a sum certain in money in return for adequate consideration in money;

• Have, at the time of issuance, a fixed stated maturity of at least five years and not more than 20 years from issuance. The stated maturity of the Subordinated Debt Note may not reset and may not contain an option to extend the maturity; and

• Be properly characterized as debt in accordance with U.S. GAAP.

The Board notes that a FISCU's legal authority to issue Subordinated Debt derives from applicable state law and regulation. For the Subordinated Debt issued by a FISCU to qualify as regulatory capital under this proposed rule, however, the FISCU would be required to comply with all of the provisions of this rule, including the FISCU-specific provisions that are detailed in section II. (C)(9) of this preamble.

2. The Board's Authority To Design RBC Standards

In addition to credit unions' authority to issue Subordinated Debt, the FCU Act also provides the Board with broad discretion to design the risk-based net worth standards.

Specifically, the FCU Act provides, in relevant part:

As discussed above, the Board finalized a rule to replace the regulatory risk-based net worth requirement with an RBC requirement.

The Board shall design the risk-based net worth requirement to take account of any material risks against which the net worth ratio required for an insured credit union to be “Adequately Capitalized” may not provide adequate protection.

12 U.S.C. 1790d(d).

In designing such a risk-based net worth standard, Congress did not restrict the types of instruments the Board may include in its calculation of risk-based net worth, except that such calculation must take account of material risks that the Net Worth Ratio alone may not protect against. The Board, as discussed in this preamble, is proposing this rule to grant authority to LICUs, Complex Credit Unions, and New Credit Unions to issue Subordinated Debt that will count as regulatory capital. Based on the requirements in this proposed rule, the Board believes Subordinated Debt will be an additional tool that accounts for material risks faced by credit unions against which the Net Worth Ratio alone may not protect.

While the Board has broad discretion to create the risk-based net worth standard, it does not have the authority to amend the statutory definition of net worth. Currently, the statutory definition of net worth includes secondary capital issued by a LICU that is uninsured and subordinate to all claims against the LICU. As such, the Board notes two points with respect to Subordinated Debt and Net Worth. First, Subordinated Debt issued by a non-LICU will not be included in that credit union's Net Worth or Net Worth Ratio. Second, Subordinated Date issued by a LICU after the effective date of a final Subordinated Debt rule will be included in that credit union's Net Worth and Net Worth Ratio.

C. Credit Union Data

Data from NCUA Call Report.

As of June 30, 2019, there are 2,618 LICUs. Under this proposed rule, LICUs would continue to be eligible to issue Subordinated Debt. This proposed rule would newly authorize certain non-LICUs to be eligible to issue Subordinated Debt. Specifically, Complex Credit Unions and New Credit Unions would also be eligible to issue Subordinated Debt. The NCUA estimates that this proposed rule would allow an additional 285 non-LICUs, with total assets of $730 billion, to issue Subordinated Debt.

Proposed eligible

# of credit

unions

Total industry assets

Average net

worth ratio

(%)

LICU

2,618

$628 billion

LICU—New Credit Union

$24 million

Non-LICU Complex Credit Union

281

$730 billion

Non-LICU New Credit Union

$12 million

Proposed Not Eligible

Non-LICU Non-Complex Credit Union

2,409

$162 billion

Total Assets and average Net Worth Ratios rounded. Only one of the 281 Non-LICU Complex Credit Unions had a Net Worth Ratio category of “Undercapitalized.”

D. Summary of the Proposed Rule

This proposed rule reflects not only the responses to the ANPR discussed above, but also research by NCUA staff, consultation with outside legal counsel, and a comprehensive review of the various current NCUA regulations, including the Current Secondary Capital Rule. The Board believes this proposal represents a balance between flexibility for credit unions and its responsibility to safeguard the NCUSIF and protect the safety and soundness of credit unions.

This proposed rule would permit LICUs, Complex Credit Unions, and New Credit Unions to issue Subordinated Debt Notes for purposes of regulatory capital treatment.

It contains a series of requirements with respect to the Subordinated Debt and Subordinated Debt Note, disclosures and offering materials, repayment (including prepayment), and regulatory capital treatment. It also includes an application procedure for both the issuance and repayment of Subordinated Debt Notes.

Regulatory capital treatment is based on the type of credit union issuing Subordinated Debt. As discussed throughout this preamble, a LICU may include Subordinated Debt in its RBC ratio and its Net Worth; a Complex Credit Union that is not a LICU may include Subordinated Debt in its RBC ratio; and a New Credit Union that is not a LICU may use Subordinated Debt to avail itself of various Prompt Corrective Actions.

In addition, the Board is proposing requirements related to the various securities law issues applicable to the offer, issuance, and sale of Subordinated Debt Notes. See sections I. (E) and II. (C)(6) and (8) in this preamble for a detailed discussion of these requirements.

This proposed rule also makes various additions and amendments to other parts and sections of the NCUA's regulations. Specifically, this proposed rule would include: A new section addressing limits on loans to other credit unions; a grandfathering of any secondary capital issued before the effective date of a final Subordinated Debt rule (Grandfathered Secondary Capital); an expansion of the borrowing rule to clarify that FCUs can borrow from any source; revisions to the RBC Rule and the payout priorities in an involuntary liquidation rule to account for Subordinated Debt and Grandfathered Secondary Capital; and cohering changes to part 741 to account for the other changes proposed in this rule that apply to FISCUs.

All secondary capital issued after the effective date of a final Subordinated Debt rule would be subject to the requirements for Subordinated Debt. This change would not impact a LICU's ability to include such instruments in its Net Worth.

As noted above, secondary capital issued before the effective date of a final Subordinated Debt rule would be considered Grandfathered Secondary Capital. This proposal would also preserve the regulatory capital treatment of Grandfathered Secondary Capital for 20 years after the effective date of a final Subordinated Debt rule. Grandfathered Secondary Capital, under this proposal, would generally remain subject to the requirements in current §§ 701.34(b) through (d) (Current Secondary Capital Rule). For ease of reference, the requirements in the Current Secondary Capital Rule would be moved from their current location to a section in the new proposed subpart.

Finally, the Board has made cohering changes to various section of the NCUA's regulations. Specifically, this proposed rule includes:

• A new § 701.25, which places limits on FCU loans to other credit unions;

• Recodification of § 701.34 (b), (c), and (d) as § 702.414 to address Grandfathered Secondary Capital;

• An update to § 701.38 that clarifies that FCUs can borrow from any source;

• Changes and additions to the final RBC Rule to account for Subordinated Debt issued by Complex Credit Unions and New Credit Unions;

• An update to the involuntary liquidation payout priorities in § 709.5 to account for Subordinated Debt; and

• Changes to part 741 to account for FISCUs investing in or issuing Subordinated Debt and the treatment of Grandfathered Secondary Capital.

These additional regulatory changes were necessary to ensure that this proposal represents a comprehensive review and revision of the NCUA's regulations to appropriately account for Subordinated Debt.

E. Securities Law Issues

1. Subordinated Debt Notes Are Securities

The NCUA continues to believe that any Subordinated Debt Note would be deemed to be a “security” for purposes of federal and state securities laws. Section 2(1) of the Securities Act broadly defines the term “security” to include, among other things, any:

• Stock;

• Note;

• Bond;

• Debenture;

• Evidence of indebtedness;

• Investment contract; or

• Interest or instrument commonly known as a security.

15 U.S.C. 77b.

The U.S. Supreme Court has repeatedly emphasized that the definition of “security” is quite broad. In a variety of cases analyzing the boundaries of the definition, the Supreme Court has stressed that the substantive characteristics of the instrument in question and the circumstances surrounding its issuance, rather than the mere name or title of the instrument, are of primary significance in determining whether the instrument, contract or arrangement in question will be deemed a “security.” While lower federal courts and some state courts have sometimes taken a more narrow view than the Supreme Court, common factors the courts generally consider in their analysis (particularly in the context of a debt instrument, contract or arrangement) include:

• The terms of the offer;

• In particular, the character of the economic inducement being offered to the potential counterparty, and whether the characteristics are consistent with a loan or typical extension of credit, or such that the counterparty would anticipate a potential return on investment in addition to repayment of the obligation and any stated interest;

• The plan of distribution;

• In particular, how the instrument is marketed and to whom it is marketed, and whether the potential counterparties are traditional lenders/providers of credit or investors who would anticipate a potential return on investment in addition to repayment of the obligation and any stated interest; and

• The “family resemblance” of the instrument to other instruments or arrangements that have been found to fall within the definition of a “security,” rather than having characteristics more akin to a loan or typical extension of credit.

The NCUA's definition of a “security” is not as broad on its face as the Securities Act definition, but is generally consistent with the federal definition, relevant case law, and interpretations by the SEC. Section 703.2 of the NCUA's regulations defines the term to include a share, participation, or other interest in property or in an enterprise of the issuer or an obligation of the issuer that:

• Either is represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer;

• Is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment; and

• Either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.

12 CFR 703.2.

For the foregoing reasons, the Board emphasizes that any issuance of a Subordinated Debt Note by an Issuing Credit Union must be done in accordance with applicable federal and state securities laws. Given the complexity of the securities law framework, any credit union contemplating an offer and sale of Subordinated Debt Notes needs to engage qualified legal counsel to ensure its compliance with securities laws before, during, and after any such offer and sale. The securities law information in this preamble does not constitute, and should not be construed or relied upon as, legal advice to any party.

2. Federal (SEC) Registration of Subordinated Debt Notes

Section 5(a) of the Securities Act expresses a fundamental premise of the federal securities laws—that any offers and sales of securities must be registered with the SEC under the Securities Act, unless an exemption from registration is available.

Sections 3 and 4 of the Securities Act outline a variety of exemptions from the registration requirements of Section 5(a).

Based on either of two exemptions discussed below, Issuing Credit Unions will be able to offer and sell their Subordinated Debt Notes without registering the offering with the SEC under the Securities Act. Specifically, an Issuing Credit Union should be able to rely on either Section 3(a)(5) of the Securities Act or Rule 506 under Regulation D promulgated under Section 4(a)(2) of the Securities Act.

15 U.S.C. 77e.

Id.

77c and 77d.

Section 3(a) of the Securities Act provides a series of exemptions from Securities Act registration based on the character of the securities being offered, without regard to the nature of the offering or the nature of the purchasers in the offering. That is, the exemption applies to offerings:

• Conducted as public offerings or as private placements or a mix of the two;

• Made to investors that are institutions, individuals, or both; and

• Made to investors whether or not the investors meet one or more standards such as “accredited investors” or “qualified institutional buyers,” as each such term is defined in SEC regulations.

Relevant to credit unions, section 3(a)(5) of the Securities Act, in relevant portion, exempts securities that are issued “by a savings and loan association, building and loan association, cooperative bank, homestead association, or similar institution, which is supervised and examined by State or Federal authority having supervision over any such institution.” The Board anticipates that nearly all Issuing Credit Unions would rely on this exemption from the registration requirements in the Securities Act.

The Board notes that, in addition to the exemption in Section 3(a)(5), Section 4(a) of the Securities Act provides certain exemptions based on the nature of the securities transaction and the persons involved in the transaction. In particular, Section 4(a)(2) provides certain exemptions (and authorizes the SEC to adopt related rules) based on the nature of the offering and the character of the offerees and purchasers of the securities, without regard to the character of the securities. That is, the exemptions apply to offerings of:

• Equity securities, including common and preferred stock and options, warrants, rights and other derivative securities;

• Debt securities, including bonds, notes and debentures; and

• Hybrid securities, including convertible securities.

Rule 506 of Regulation D, which was adopted by the SEC under Section 4(a)(2) of the Securities Act, provides the specific requirements of one form of what is commonly referred to as the “private placement” exemption. Under Regulation D, Rule 506, registration under the Securities Act is not required for offerings that are either (i) not made via any means of general solicitation or advertisement and where the number of purchasers who are not “accredited investors” is limited to no more than 35, or (ii) made via general solicitation or advertisement but where all purchasers are “accredited investors”.

Given the time and costs associated with offering and selling SEC-registered securities, the Board recognizes that many Issuing Credit Unions may avail themselves of an exemption from the registration requirements of Section 5(a) of the Securities Act. Under this proposed rule, the Board would not mandate a specific exemption on which an Issuing Credit Union could or should rely. An Issuing Credit Union should consult with its securities counsel in determining the appropriate exemption upon which to rely.

As discussed more fully in sections II. (C)(6) and (8) of this preamble, however, the Board is proposing to adopt a regulatory framework for the offer, issuance, and sale of Subordinated Debt Notes. This framework is independent of any available exemptions from the registration requirements of Section 5(a) of the Securities Act. It also generally aligns with certain disclosure requirements in the OCC's subordinated debt regulations. For example, the Board is proposing that every planned issuance of Subordinated Debt Notes would require an Issuing Credit Union to prepare and deliver an Offering Document to potential investors even though there are no SEC-mandated disclosure requirements for offerings of securities pursuant to the Section 3(a)(5) exemption, and there generally are no SEC-mandated disclosure requirements

for offerings of securities pursuant to the Rule 506 private placement exemption as long as all purchasers in the offering are “accredited investors.”

The Board believes that adopting this regulatory framework would benefit both Issuing Credit Unions and investors, as the framework would provide potential investors information that is important to making a decision to invest in Subordinated Debt Notes and would clearly define the obligations of the related Issuing Credit Unions. These are important benefits that can reduce the possibility of investor confusion or misunderstandings and can assist an Issuing Credit Union in defending against claims by investors that they had a different understanding about the Issuing Credit Union, the terms of the offering, or the securities based on statements made by the Issuing Credit Union or its agents.

Finally, the Board notes that the OCC also applies a regulatory framework to the offer, sale, and issuance of subordinated debt securities. The OCC's subordinated debt regulations require banks to comply with the OCC's registration requirements or otherwise qualify for an exemption under part 16 of those regulations. In particular, the OCC requires that any offers and sales of nonconvertible subordinated debt securities be made only to “accredited investors” and only after offering materials have been provided to potential investors.

3. State Registration of Subordinated Debt Notes

Each state has its own securities laws and regulations and regulators charged with the duty of enforcing those laws and regulations. The states have general authority to regulate securities offerings and related matters occurring within or affecting their states. However, the federal securities laws include a number of provisions that substantially limit or completely preempt certain types of state regulation.

Section 18 of the Securities Act

provides that securities that meet the definition of “covered securities” are not subject to any form of substantive state securities regulation. States do retain authority to pursue fraud-based enforcement claims and the ability, under some circumstances, to require issuers to submit notice filings to the state, which allows the state to collect a filing fee.

15 U.S.C. 77r.

Securities that fall within the Section 3(a)(5) exemption, as well as securities issued in an exempt offering under Regulation D, Rule 506, both meet the definition of “covered securities.” As a result, in connection with any Subordinated Debt Notes offerings by Issuing Credit Unions that comply with the requirements of Section 3(a)(5) or Regulation D, Rule 506, state securities regulators will not be permitted to:

• Impose any registration, qualification or pre-clearance requirements on the issuer, the terms of the offering or the securities being offered;

• Assess the merits of the issuer, the terms of the offering or the securities being offered; or

• Require the delivery of any disclosure to potential purchasers of the securities in connection with the offering.

4. Disclosure Requirements and Anti-Fraud Provisions

Although Section 3(a)(5) and Regulation D, Rule 506 provide exemptions from the registration requirements of the Securities Act, and reliance on those exemptions is not conditioned on the delivery of any required disclosure to potential investors (in the case of the traditional Rule 506 private placement under Rule 506(b), as long as all the investors are “accredited”), the marketing and sale of the securities remain subject to the broad anti-fraud prohibitions of the Securities Exchange Act of 1934, as amended (Exchange Act).

The Exchange Act's general anti-fraud prohibitions are embodied in § 10(b), which generally prohibits the use of manipulative or deceptive devices or contrivances that violate SEC rules in connection with the purchase or sale of securities.

Most of the litigation brought with respect to the rules promulgated under § 10(b) has been brought under the general anti-fraud provision, Rule 10b-5, which provides as follows:

17 CFR 240.10b-5.

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) to employ any device, scheme, or artifice to defraud,

(b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Id.

The primary intent of Rule 10b-5 (and, more broadly, the anti-fraud provisions of the Securities Act and the Exchange Act) is to prevent fraud, deceit, and incorrect or misleading statements or omissions in the offering, purchase and sale of securities. Given that intent, clear and complete disclosure is the critical factor in ensuring the anti-fraud provisions of the Securities Act and Exchange Act are not breached in any offering of securities, regardless of whether the offering is registered with the SEC under the Securities Act or exempt from registration.

In the absence of SEC-mandated disclosure delivery requirements, the practical concern for Issuing Credit Unions relying on either the Section 3(a)(5) or Regulation D, Rule 506 exemption is determining what type and amount of disclosure is appropriate to meet the anti-fraud standards. Relevant case law suggests that the type and amount of disclosure varies depending on a number of surrounding facts and circumstances, including:

• The nature of the potential investors (focusing on their level of sophistication);

• The nature of the security being offered (disclosure regarding the terms of debt instruments, preferred stock or more complex securities tends to be more detailed than disclosure regarding common stock);

• The nature of the business of the issuer and the industry in which the issuer operates (detailed disclosure may be more appropriate in the case of complex business structures and industries); and

• Market practices (focusing on the types of disclosure commonly provided by peer companies).

There are a number of advantages in using a well-written disclosure document in connection with any offering of securities. First, using a disclosure document provides both the issuer and potential investors with a centralized resource clearly and consistently setting forth the terms of the offering and the securities being offered. Second, the disclosure document can be used as a reference to reduce the possibility of investor confusion or misunderstandings and can be used by the issuer as a defense against claims by investors that they had a different understanding about the issuer, the terms of the offering, or the securities based on statements made by the issuer or its agents. For these reasons, the Board is proposing that every planned issuance of Subordinated Debt Notes would require the preparation and delivery of a written

disclosure document, each of which must meet the standards of Rule 10b-5.

In brief, for any disclosure document to meet the standards of Rule 10b-5, the disclosure included in the document (a) must not contain any untrue statement of a material fact and (b) must not omit to state a material fact the absence of which renders any disclosure already being made misleading. To accomplish those ends, the disclosure must be clear, accurate, and verifiable. In addition, the disclosure should cover topics that are typically important to investors in making an investment decision. Common topics in this category include:

• Material risks relating to the issuer and the industry in which the issuer operates;

• Material risks relating to the security being offered;

• The issuer's planned uses for the proceeds of the offering;

• Regulatory matters impacting the issuer and its operations;

• Tax issues associated with the security being offered; and

• How the securities are being offered and sold, including any conditions to be met in order to complete the offering.

Sections 702.405, 702.406, and 702.408 of the proposed rule detail the Offering Document requirements for a planned issuance of Subordinated Debt Notes. These requirements are independent of and, in some cases, additive to any requirements imposed by applicable securities laws. The Board reiterates its expectation that credit unions contemplating an issuance of Subordinated Debt Notes retain professional advisors experienced in securities law disclosure matters to assist them in the preparation of related Offering Documents.

Beyond the disclosure topics outlined above, a credit union considering issuing Subordinated Debt Notes may obtain guidance as to the type and amount of disclosure that is appropriate for its securities offerings from market participants. Sophisticated investors, rating agencies, underwriters, placement agents, and others often exert significant influence over disclosure practices in exempt securities offerings. In some settings, such as municipal bond offerings and offerings under Securities Act Rule 144A

(made to highly sophisticated “qualified institutional buyers”), it is not uncommon for disclosure documents to approach the level of detail that typically would be provided in a registration statement for an offering registered with the SEC under the Securities Act.

17 CFR 230.144A.

5. Ongoing Disclosure and Reporting to Investors; Investor Relations

As discussed in this preamble, the SEC does not mandate any specific disclosure, either in form or substance, with respect to offers and sales of securities under the Section 3(a)(5) exemption or the Regulation D, Rule 506 exemption (if sales are made only to “accredited investors;” sales to other investors do require the issuer to deliver specific types of disclosure). Similarly, SEC rules do not require companies that have relied on those exemptions to distribute or make available any disclosure after the offering has been completed or at any time in the future. As noted above, the preemptive effect of Section 18 of the Securities Act prohibits states from requiring any ongoing disclosure to investors following completion of an offering of “covered securities.”

It is often the case, however, that investors will require that the issuer provide some form of ongoing disclosure. Securities purchase agreements, or companion “investor rights agreements,” often specify the form and content of the ongoing disclosure and the frequency of delivery of the disclosure. Practice varies from a requirement to deliver quarterly and annual financial statements to disclosure in form and substance that mimics the disclosure an SEC-registered company would be required to provide to its investors. In addition, for issuances of debt securities under an indenture or an issuing and paying agent agreement, the terms of those documents commonly include requirements to provide certain information to the trustee or paying agent on an ongoing basis, and that information is either passed on directly to investors or is generally available to investors by request to the trustee or paying agent.

Even in the absence of mandated or contractual requirements to provide disclosure, Issuing Credit Unions issuing Subordinated Debt Notes will likely face a variety of practical, disclosure-related issues. For example, investors frequently contact companies in which they hold an interest and ask for a variety of information about the company, its operations, its financial performance, and its prospects. While an Issuing Credit Union may prefer not to respond to those inquiries, from an investor relations standpoint, refusing to respond is not likely to be practical. Although this places certain burdens on an Issuing Credit Union's management, maintaining open lines of communication with investors can have significant practical benefits, including assessing possible interest in future offerings of Subordinated Debt Notes, negotiating possible buybacks of outstanding Subordinated Debt Notes, or negotiating amendments or modifications to obligations relating to any currently outstanding Subordinated Debt Notes.

From a securities law standpoint, the type of information an Issuing Credit Union provides—and whether that information is provided only to the requesting investor, to all investors, or the marketplace—generally raises a number of important issues. First, any information that is provided must be materially correct and complete, because the anti-fraud provisions of the securities laws could apply to those communications if an investor or potential investor relies on those communications in connection with the purchase or sale of a security. In addition, sharing material, non-public information with individual investors without making that information generally available to all investors could result in potential liability for the Issuing Credit Union.

As a result, for securities law compliance and risk management purposes, under the proposed rule, Issuing Credit Unions issuing Subordinated Debt Notes must adopt policies and procedures covering matters such as:

• Who is responsible and authorized to speak on behalf of the Issuing Credit Union;

• What information will and will not be provided to requesting investors;

• Whether that information will be made available to other investors; and

• How that information will be made available to other investors.

Although an Issuing Credit Union may not need to have full-time personnel dedicated to an investor relations function, some personnel will need to take on responsibility for investor relations, and will need to be prepared to accurately answer questions and respond to appropriate requests. In addition, the responsible personnel will need to be trained regarding appropriate boundaries for responses to and discussions with investors. As noted above, there are a variety of securities law issues relating to communications with investors. As a result, for securities law compliance and risk management purposes, Issuing Credit Unions issuing Subordinated Debt Notes will need to adopt certain policies and procedures covering interactions with investors.

Finally, similar to commercial loans, lines of credit, and other types of debt financing, the debt security instrument

itself and/or the documents relating to debt securities issuances (for example, note purchase agreement, indenture, issuing and paying agent agreement) customarily require the issuer of debt securities to report its compliance (or non-compliance) with any covenants included in the terms of the debt securities. The frequency of reporting and the contents of the report can vary from situation to situation, based both on the demands of the investors and the term structure of the particular debt security. These obligations will make it necessary for the Issuing Credit Union to implement compliance and reporting controls and procedures to ensure compliance with the terms of the Subordinated Debt Notes generally, and for compliance with any applicable reporting requirements.

6. Potential Broker-Dealer Registration Issues

Marketing activities by an Issuing Credit Union and its employees in connection with any offerings of Subordinated Debt Notes could require the employees to register as broker-dealers because the SEC interprets the definition of “broker” broadly to cover persons who play almost any active role in offers and sales of securities, including, under certain circumstances, employees of the issuer of the securities or its affiliates.

There are exemptions available to both an Issuing Credit Union itself and its employees that can excuse them from the broker-dealer registration requirements. Credit unions that issue securities typically cannot be “brokers” of their own securities because they are not involved in the purchase or sale of securities for the account of other persons. Similarly, credit unions that issue securities typically cannot be “dealers,” because their normal business does not involve buying and selling their own securities for their own account. Credit union employees that participate in offering-related activities usually will be able to rely on the exemption provided by Rule 3a4-1 under the Exchange Act.

Conditions to relying on this exemption include the employee:

17 CFR 240.3a4-1.

• Not receiving commissions or other compensation relating to the offering;

• Not being disqualified under SEC rules due to past legal or regulatory issues;

• Not being associated with a broker or dealer during the offering; and

• Either limiting his or her offering-related activities, limiting the types of potential investors he or she interacts with, or limiting the number of offerings he or she participates in.

As a result, for securities law compliance and risk management purposes, discussed further in section II(C)(8) of this preamble, Issuing Credit Unions must adopt certain policies and procedures covering compliance with broker-dealer requirements.

7. Director and Officer (“D&O”) Liability Insurance Coverage for Issuing Credit Unions

Under the proposed rule, Issuing Credit Unions considering issuing Subordinated Debt Notes will need to evaluate the potential impact of those activities on their D&O coverage. The scope of D&O liability coverage, amount of premiums, and terms relating to retention (deductibles and self-insurance) are usually different for public companies versus private companies. While Issuing Credit Unions will not be “public” in the same way SEC-registered entities with securities traded on an exchange are, entities that begin issuing securities to more than a limited number of “outside” investors must often make adjustments to their existing D&O policies.

For the reasons identified in subsections I. (E)(5), (6), and (7) above, the Board is proposing to require a credit union to include draft written policies on these issues as part of its application to issue Subordinated Debt Notes. See section II. (C)(8) of this preamble for a more detailed discussion of the application requirements.

II. Proposed Changes

The following is a section-by-section analysis of the proposed changes. The Board invites comment on each proposed change and, where appropriate, has posed questions to solicit specific feedback on discrete aspects of the proposed rule. The Board notes that all references in this preamble to part 702 of the NCUA's regulations, including any subsection thereof, refer to the version of part 702 that gives effect to the final RBC Rule and which will become effective on January 1, 2022.

A. Part 701—Organization and Operations of Federal Credit Unions

1. § 701.25 Loans to Credit Unions

The Board proposes to add a new § 701.25 for FCUs making loans to other credit unions. This section will only apply to natural person credit unions; corporate credit union lending is subject to § 704.7.

While this section applies to FCUs, FISCUs will be subject to these requirements and limitation through the proposed § 741.227 as discussed in section II. (E)(3) of this preamble. Loans from FCUs to other credit unions are not currently addressed in the NCUA's regulations. The Board believes adding a new section for loans to credit unions will establish policy standards and limits to support safety and soundness and protect the NCUSIF.

The NCUA is evaluating a potential proposed rule to clarify the extent to which corporate credit unions could purchase Subordinated Debt issued by natural person credit unions.

The loans to other credit unions section includes the following FCU activities:

These requirements do not apply to natural person credit union investments in contributed capital of corporate credit unions, which is limited by 12 CFR 703.14(b).

• Loans not subordinate to the NCUSIF or to a private insurer (for privately insured credit unions);

• Subordinated Debt;

• Grandfathered Secondary Capital; and

• Loans or obligations subordinate to a private insurer (for privately insured credit unions).

Specifically, the proposed § 701.25 will establish:

• Limits on loans an FCU makes to other credit unions;

• Approval and policy standards for an FCU to make loans to other credit unions; and

• Requirements and limits on an FCU making investments in Subordinated Debt.

The Board proposes § 701.25(a) to establish aggregate and single borrower limits for loans, including investments in Subordinated Debt, an FCU can make to other credit unions. The proposed aggregate limit is the same as the limit in the FCU Act on an FCU's authority to invest its funds in loans to other credit unions.

The single borrower limit is consistent with the single borrower limit in § 723.4(c) for commercial loans.

12 U.S.C. 1757(7)(C).

The Board notes that the FCU Act imposes an aggregate limit on the amount of loans an FCU may make to other credit unions. Specifically, the FCU Act authorizes an FCU to make loans to other credit unions that, in the aggregate, cannot exceed 25 percent of the FCU's paid-in and unimpaired capital and surplus.

Paid-in and unimpaired capital and surplus is defined in NCUA regulations as:

Id.

[S]hares plus post-closing, undivided earnings. This does not include regular reserves or special reserves required by law, regulation or special agreement between the

credit union and its regulator or share insurer.

12 CFR part 700.

The proposed aggregate limit in this section, therefore, is not a substantive change, but a regulatory codification of the limit imposed by the FCU Act. The Board believes the proposed rule would clarify loan limits in this section and minimize the need for readers to reference the FCU Act when determining aggregate limits for loans to credit unions.

The Board is proposing a new single borrower limit for FCUs making loans to other credit unions that would be the greater of 15 percent of the FCU's Net Worth or $100,000, plus an additional 10 percent of the FCU's Net Worth if that amount is fully secured at all times with a perfected security interest by readily marketable collateral as defined in § 723.2. There is no current single credit union borrower limit in the NCUA's regulations. The Board notes that the proposed single borrower limit is consistent with the single borrower limit in the NCUA's commercial lending and MBL rule.

Because credit unions share many similarities with traditional corporate borrowers, the Board believes that basing the proposed single borrower limit in this rule on the commercial and MBL rule limit is appropriate. Furthermore, the 15 percent of Net Worth single borrower limit for FCUs making loans to other credit unions would generally limit catastrophic losses to an FCU if the borrower defaults. The proposed 15 percent of Net Worth threshold is also consistent with the longstanding FDIC single-obligor limit.

The Board would like to note that it is also considering a similar single obligor limit for uninsured deposits in future rulemakings.

Id.

723.4(c).

Id.

32.3(a).

The Board proposes § 701.25(b) to establish minimum approval and written policy standards for an FCU that is making loans to credit unions. The proposal would require that an FCU's board of directors approve all loans to other credit unions. The Board notes that the FCU Act already requires an FCU's board of directors to approve all loans to credit unions and, as such, this proposed requirement is not new.

12 U.S.C. 1757(5)(C).

The proposed rule also requires an FCU lending to another credit union to establish written policies that address how it would manage the risk of its loans to credit unions and the dollar limits, both aggregate and single borrower, on the amount of the loans. This would be a new requirement for FCUs making loans to other credit unions.

The Board is proposing to add this requirement because it believes that making loans to credit unions should have similar policy requirements as other loans and investments. The Board also believes written policies can help ensure FCU lending to other credit unions will operate in a safe and sound manner. Policies create a framework for a credit union to consistently perform credit analysis and creates limits that are consistent with the credit union's risk tolerance and regulatory limits to help ensure the credit union is operating in a safe and sound manner.

The Board believes that FCUs that make loans to other natural person credit unions may have traditionally included policies for this activity in their investment or loan policies. The Board believes including policies for loans to other credit unions in the investment policy or a loan policy is sufficient for compliance with this requirement, since the Board's concern is with the existence of sufficient policies, not where they reside.

The Board is proposing § 701.25(c) to establish minimum requirements and limits for an FCU that invests in Subordinated Debt, Grandfathered Secondary Capital or in loans and obligations issued by privately insured credit unions that are subordinate to a private insurer (PICU Subordinated Debt). The minimum requirements apply to both direct and indirect investments.

direct investment

would have the issuer of the Subordinated Debt as the borrower on the investing credit union's balance sheet. For example, credit union A purchases Subordinated Debt from credit union B. This results in credit union A having risk exposure (credit risk) to credit union B through its holding of the Subordinated Debt note.

indirect investment

is one in which the issuer of the Subordinated Debt is not identifiable on the investing credit union's balance sheet. An example of an indirect investment would be the purchase of shares in a mutual fund. For example, XYZ mutual fund purchases Subordinated Debt issued by credit union B. If credit union A purchases shares in this mutual fund, then credit union A would have an indirect investment in credit union B's Subordinated Debt, because only XYZ mutual fund would be recorded on credit union A's balance sheet.

The Board is proposing that an FCU must meet three criteria to make direct or indirect investments in Subordinated Debt, Grandfathered Secondary Capital or PICU Subordinated Debt. Specifically, the investing FCU:

• Has, at the time of the investment, a capital classification of “Well Capitalized;”

• Does not have any outstanding Subordinated Debt or Grandfathered Secondary Capital with respect to which it was the Issuing Credit Union; and

• Is not eligible to issue Subordinated Debt or Grandfathered Secondary Capital pursuant to an unexpired approval from the NCUA.

The Board is proposing the “Well Capitalized” capital classification requirement because it believes that only “Well Capitalized” FCUs should invest in obligations of natural person credit unions that are subordinate to the NCUSIF or to a private insurer. Because any of the aforementioned subordinated obligations are in a first loss position, even before the NCUSIF or a private insurer, an involuntary liquidation of the related Issuing Credit Union or significant write-downs of the subordinated obligations would potentially mean large, and likely total, losses for the holders of those subordinated obligations. Therefore, the Board believes it would not be safe and sound to allow FCUs that are classified less than “Well Capitalized” to invest in Subordinated Debt, Grandfathered Secondary Capital or PICU Subordinated Debt.

Conversely, the Board believes that a “Well Capitalized” FCU generally has sufficient Net Worth to invest in Subordinated Debt, Grandfathered Secondary Capital or PICU Subordinated Debt, provided that the risk is limited as discussed further in this section of the preamble.

The Board is also proposing that an FCU investing in Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt must not be an Issuing Credit Union of Subordinated Debt or Grandfathered Secondary Capital, or currently have approval from the NCUA to issue Subordinated Debt or Grandfathered Secondary Capital. The Board notes that an FCU would not be considered an Issuing Credit Union if it acquired Subordinated Debt or Grandfathered Secondary Capital issuance through a merger, as discussed further in section II. (C)(3) of this preamble. The Board believes that an Issuing Credit Union should not provide Regulatory Capital to other natural person credit unions. Furthermore, the potential to transmit losses between multiple Issuing Credit Unions that have both issued Subordinated Debt and invested in Subordinated Debt (loss transmission) could increase the risk of credit union failure and increase the

risk to the NCUSIF. For example, if an Issuing Credit Union both purchased and issued Subordinated Debt, losses from the Subordinated Debt

purchased

by the Issuing Credit Union could create losses on the Subordinated Debt

issued

by the Issuing Credit Union, thereby creating a potential loss transmission from the purchased Subordinated Debt to the issued Subordinated Debt. The Board is concerned that, if it does not restrict covered credit unions in this way, a loss incurred by an Issuing Credit Union would simultaneously transmit to an investing credit union (the credit union that is the purchaser of the issuer's Subordinated Debt Note). This inter credit union exposure results in an imprudent transmission of losses because a single loss can impact both institutions rather than the issuer alone. The Board believes that failing to prohibit inter credit union subordinated debt transactions will create an unsafe and unsound condition for the NCUSIF.

Beyond loss transmission, if the Board were to allow Issuing Credit Unions to invest in Subordinated Debt, the level of Net Worth in the credit union system could appear to increase, while the actual loss-absorbing capacity of the system would remain unchanged. For example, two LICUs each have $10 million in Net Worth, so the total Net Worth between the two credit unions is $20 million. If each credit union issued $1 million in Subordinated Debt and then sold it to the other, the Net Worth between the two credit unions would be $22 million. This would result in an artificial $2 million increase (ten percent) in Net Worth for the credit union system, and would increase potential loss transmission between the two credit unions as explained in the prior paragraph. The Board notes the increased total Net Worth in the system described above would also happen if only one credit union issued the Subordinated Debt and the other credit union purchased it, also artificially increasing the Net Worth in the system.

The Board is proposing limits on the amount of investment an FCU can make in Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt. The proposed limit is only on an aggregate basis, because single borrower limits have been addressed in the proposed general single credit union borrower limit. The Board is proposing an aggregate limit of the lesser of 25 percent of Net Worth and any amount of Net Worth in excess of 7 percent of total assets.

The Board believes a cap of 25 percent of Net Worth is appropriate given the higher relative risk of loss with Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt. This risk comes from the Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt being in a position to incur losses before the NCUSIF or a private insurer. In other words, the Subordinated Debt and Grandfathered Secondary Capital will take losses after retained earnings before the NCUSIF. The loss profile of Subordinated Debt and Grandfathered Secondary Capital would also apply to PICU Subordinated Debt.

Past loss experience in credit union involuntary liquidations shows that it is not unusual for the NCUSIF to take losses in a liquidation. Any loss to the NCUSIF in a liquidation would result in a total loss of the Subordinated Debt and Grandfathered Secondary Capital. The risk for PICU Subordinated Debt would be similar to Subordinated Debt and Grandfathered Secondary Capital if a private insurer takes losses.

The Board believes the severity of the potential loss warrants an aggregate limit on Subordinated Debt, Grandfathered Secondary Capital, and PICU Subordinated Debt of 25 percent of Net Worth. The Board also contemplated aggregate limits of 15 percent and 40 percent of Net Worth, but believes an aggregate limit of 25 percent of Net Worth strikes an appropriate balance between granting FCUs flexibility to invest, and the risks associated with Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt. The Board requests specific comment on whether the NCUA should consider a different aggregate limit, such as 15 percent of an FCU's Net Worth or 40 percent of Net Worth. The Board notes that this limit does not apply to natural person credit union investments in contributed capital of corporate credit unions, which is limited by § 703.14(b).

The Board is also proposing another measure of the aggregate limit, which could further restrict the amount of an FCU's investments in Subordinated Debt, Grandfathered Secondary Capital, and PICU Subordinated Debt. This limit is the amount of Net Worth in excess of seven percent of total assets. An FCU would calculate the amount of Net Worth in excess of 7 percent and would use this measure as the aggregate limit if it is an amount less than 25 percent of its Net Worth.

The Board is proposing the aforementioned limit to ensure that total potential losses from Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt would not lower an FCU's Net Worth to below seven percent, which is “Well Capitalized” when measuring using the Net Worth Ratio. As mentioned earlier, the Board believes this is an important measure to promote safety and soundness when an FCU invests in Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt.

Examples of the aggregate limit calculations are provided below.

ABC FCU Has $100 Million in Net Worth and $1 Billion in Assets

Limit type

Limit calculation

Total

(million)

Percent of Net Worth Limit

25 percent of $100 million (Net Worth)

$25.

Amount of Net Worth in excess of 7%

$100 million (Net Worth) minus [$1 billion (current assets) times 7%]

30.

Maximum amount of Subordinated Debt, Grandfathered Secondary Capital, and PICU Subordinated Debt ABC FCU invest in

Lesser of the calculations

25.

In the above example, the percentage of Net Worth limit is the lesser of the measures and therefore is the binding constraint.

LMN FCU Has $80 Million in Net Worth and $1 Billion in Assets

Limit type

Limit calculation

Total

(million)

Percent of Net Worth Limit

25 percent of $80 million (Net Worth)

$20.

Amount of Net Worth in excess of 7%

$80 million (Net Worth) minus [$1 billion (current assets) times 7%]

10.

Maximum amount of Subordinated Debt, Grandfathered Secondary Capital, and PICU Subordinated Debt ABC FCU invest in

Lesser of the calculations

10.

In the above example, the amount of Net Worth in excess of seven percent limit is the lesser of the measures and therefore is the binding constraint.

The Board is proposing a paragraph that would prescribe how the components of the aggregate limit are calculated. The limit is based on an FCU's aggregate outstanding:

• Investment in Subordinated Debt;

• Investment in Grandfathered Secondary Capital;

• Investment in PICU Subordinated Debt; and

• Loans or portion of loans made by the credit union that are secured by any Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt.

The Board is proposing this paragraph to ensure FCUs are more readily aware of the components that are subject to the aggregate limit in this section. In proposing to include loans, or portions of loans, secured by the first three components, the Board is including an exposure that could otherwise be unaccounted for by the lending credit union if the secured borrower defaults.

The Board is proposing a paragraph for the calculation of an FCU's indirect investment in Subordinated Debt, Grandfathered Secondary Capital, or PICU Subordinated Debt. The Board is proposing this paragraph to ensure FCUs consistently measure indirect investment exposure. The credit union would be required to determine the percentage of a mutual fund's assets invested in such instruments and multiple that percentage by its own pro rata investment. This will ensure the credit union has an accurate evaluation of its indirect exposure to Subordinated Debt, Grandfathered Secondary Capital and PICU Subordinated Debt. In turn, this evaluation can be used to monitor compliance with the aggregate regulatory limit on such instruments. This calculation is similar to the full look-through approach for investment funds in Appendix A of the RBC Rule. An example of the calculation follows:

ABC Fund is a $100 million fund and has $5 million of its holdings in Grandfathered Secondary Capital. XYZ FCU owns $10 million of ABC Fund.

• XYZ FCU's proportional ownership of the ABC Fund: $10 million divided by $100 million equals ten percent of the fund.

• Indirect exposure: $5 million (Grandfathered Secondary Capital) in ABC Fund times ten percent equals $500,000.

In the example above, XYZ FCU's indirect exposure, for aggregate limit calculation purposes, would be $500,000. This is the amount that would need to be included in the calculation of the aggregate limit.

2. § 701.34 Designation of Low-Income Status

The Current Secondary Capital Rule contains information on how a credit union can obtain a low-income designation and the procedures and regulations related to secondary capital. As discussed in section II. (C)(1) of this preamble, under this proposed rule, secondary capital and Subordinated Debt would be subject to nearly identical rules. As such, for ease of use, the Board is proposing to locate all regulations related to Subordinated Debt in proposed subpart D of part 702.

To accomplish this, the Board is proposing to delete subsections (b) through (d) and the appendix to the Current Secondary Capital Rule. (Subsection (a) of the Current Secondary Capital Rule would remain in place.) As discussed below, the Board is proposing to relocate subsections (b)-(d) to § 702.414 of proposed subpart D to part 702. The Board believes having one part that addresses capital and capital treatment will help users more easily review all related requirements, including Grandfathered Secondary Capital and Subordinated Debt provisions.

3. § 701.38 Borrowed Funds

The Board is proposing to revise an FCU's borrowing authority under § 701.38 to permit borrowing from any source. This is a change from the current rule, which only addresses an FCU's borrowings from “natural persons.” The Board is proposing to revise the current rule to clarify that an FCU may borrow from any source. This change is consistent with section 1757(9) of the FCU Act and, in the Board's view, supports an FCU's legal authority to issue Subordinated Debt Notes.

Id.

1757(9) (FCUs are subject to a maximum borrowing authority “in an aggregate amount not exceeding, except as authorized by the Board in carrying out the provisions of subchapter III, 50 per centum of its paid-in and unimpaired capital and surplus: Provided, [t]hat any Federal credit union may discount with or sell to any Federal intermediate credit bank any eligible obligations up to the”).

The Board also is proposing other clarifying revisions to § 701.38(a). Under the proposed rule, an FCU's borrowings would be evidenced by a “written contract,” as opposed to the more narrow language of current § 701.38(a), which provides that a borrowing must be evidenced by “a promissory note.” The Board recognizes that, under current practice, borrowing contracts may take forms other than just a promissory note. The proposal still cites a promissory note as a primary example, but extends greater flexibility than current § 701.38(a) for what is an acceptable form of evidencing the borrowing.

The Board is also proposing to revise § 701.38(a)(2) to introduce the term “funds” to modify the description of a borrowing transaction to make it clearer to investors that such transactions are not shares of the Issuing Credit Union and, therefore, are not insured by the NCUA. The Board regards both of these changes as important clarifications that will benefit credit unions and investors.

Lastly, the Board is proposing to revise § 701.38(b) to reference the limitations on an FCU's maximum borrowing authority by citing section 1757(9) of the FCU Act and removing the current reference to § 741.2 of the NCUA's regulations. However, under § 741.2, a FISCU would be subject to the same borrowing limits as an FCU under § 701.38. This technical refinement supports greater clarity in the regulation but does not change the amount of the limitation that currently applies to FCUs and FISCUs.

B. Part 702—Capital Adequacy

1. § 702.2 Definitions

The Board is proposing to add an introductory statement to the definitions section to indicate that all accounting terms not otherwise defined in the section will have the same meaning as in U.S. GAAP. The Board is adding this statement to clarify that, if an accounting term is not defined in the rule text, the reader should use any applicable definition provided under U.S. GAAP for that term. This clarifying statement supports the current practice of using U.S. GAAP definitions when an accounting term is undefined by the FCU Act or the NCUA's regulations.

The Board is amending the definition of Net Worth. In the first sentence of the Net Worth definition, the Board is clarifying that the definition of Net Worth in this section is for natural person credit unions and is specifying the measurement of Net Worth is as of the date of determination. The definition in the current rule begins with “Net worth means,” and does not explicitly state that the Net Worth definition is for natural person credit unions. The Board is adding this phrasing to avoid the possibility of confusion that the definition of Net Worth could apply to corporate credit unions. The Board is also adding the new qualifier, “as of any date of determination,” to clarify that there is an “as of” date, which is addressed below.

For clarification, the Board is proposing a technical, non-substantive refinement to the definition of Net Worth in paragraph (1) of current § 702.2 by adding “most recent” as a reference point for the date of determination. Current § 702.2 does not explicitly state that Net Worth is measured as of the most recent quarter end, but the Board believes that this reflects the common understanding within the credit union industry.

The Board is also proposing to change the wording regarding how U.S. GAAP is referenced when determining Net Worth from “as determined under U.S. GAAP” to “as determined in accordance with U.S. GAAP.” The Board believes that this non-substantive revision is more accurate than current § 702.2.

The Board is proposing to amend paragraph (2) in the Net Worth definition to include Subordinated Debt and to replace the term secondary capital accounts with Grandfathered Secondary Capital. It notes that these cohering changes are necessary based on other provisions of the proposed rule discussed throughout this preamble.

The Board is also proposing an addition to paragraph (2) that clarifies the amounts of Subordinated Debt and Grandfathered Secondary Capital that count towards Regulatory Capital.

In the current rule, the reader would need to know that secondary capital accounts have a schedule to reduce the recognition of Net Worth once they have a remaining maturity of five years or less. The Board believes that referencing the recognition of Net Worth in §§ 702.407 and 702.414 in the proposal would add clarity in calculating New Worth for LICUs that have issued Subordinated Debt or Grandfathered Secondary Capital. The Board is also proposing some formatting changes in paragraph (2) by adding two subparagraphs, (A) and (B), with text contained in a long paragraph in the current rule. The wording is unchanged except for “National Credit Union Share Insurance Fund” being spelled out. The Board is proposing this change to add ease for the reader.

Regulatory Capital is capital, both Net Worth and/or the RBC numerator, as defined by NCUA. See section II(C)(2) of the preamble for more details.

The Board is also adding new definitions for Grandfathered Secondary Capital and Subordinated Debt, as current § 702.2 does not have these definitions. The definition of Grandfathered Secondary Capital is “any subordinated debt issued in accordance with current § 701.34 (recodified as § 702.414 of subpart D of this part) or, in the case of a FISCU, with § 741.204(c) before the effective date of a final Subordinated Debt regulation. The Board is proposing to add the definition of Grandfathered Secondary Capital as a way to refer to secondary capital issued under the current rule, as discussed in more detail in section II. (C)(14) of this preamble.

Finally, the Board is also proposing to add a definition of Subordinated Debt, which will be the same as the meaning in the proposed subpart D. The definition of Subordinated Debt is “an Issuing Credit Union's borrowing that meets the requirements of this subpart, including all obligations and contracts related to such borrowing.” This definition is discussed in more detail in section II. (C)(2) of this preamble. The Board is adding a definition of Subordinated Debt so a reader of the proposed rule text outside of subpart D knows where to find the definition.

2. § 702.104 Risk-Based Capital Ratio

The Board is proposing to amend current § 702.104(b)(1)(vii) to include both Subordinated Debt and Grandfathered Secondary Capital in the RBC Ratio.

Current § 702.104(b)(1)(vii) allows secondary capital accounts to be included in the RBC numerator. This change is necessary to properly give effect to Subordinated Debt and Grandfathered Secondary Capital in the RBC Ratio.

The RBC Ratio is calculated using a numerator and a denominator. The numerator includes (i) Undivided earnings; (ii) Appropriation for non-conforming investments; (iii) Other reserves; (iv) Equity acquired in merger; (v) Net income; (vi) ALLL, maintained in accordance with U.S. GAAP; (vii) Secondary capital accounts included in net worth (as defined in § 702.2); and (viii) Section 208 assistance included in net worth (as defined in § 702.2) and deductions for (i) NCUSIF Capitalization Deposit; (ii) Goodwill; (iii) Other intangible assets; and (iv) Identified losses not reflected in the RBC Ratio numerator. The denominator includes risk-weighted assets.

The Board is also clarifying that the amount of Subordinated Debt and Grandfathered Secondary Capital that is treated as Regulatory Capital, as discussed in section II. (C)(7) of this preamble, would be included as part of the RBC Ratio. Currently, the definition does not establish how secondary capital would be included in the RBC Ratio, but the Board intended that only the non-discounted portion of secondary capital would count in the RBC Ratio. Therefore, in this proposal, the Board is clarifying that only the portion of Grandfathered Secondary Capital and Subordinated Debt that counts as Regulatory Capital would be included in the RBC Ratio.

Currently, the RBC Rule does not specifically include secondary capital or obligations issued by privately insured credit unions that are subordinate to a private insurer in any risk weighting category. As such, secondary capital and obligations issued by privately insured credit unions that are subordinate to a private insurer would be risk weighted at 100 percent under the “(a)ll other assets listed on the statement of financial condition not specifically assigned a different risk weight under this subpart” category.

12 CFR 702.104(c)(2)(v)(C).

The Board is proposing to add a new § 702.104(c)(2)(v)(B)(

) that would assign a 100 percent risk weight to the exposure amount of natural person credit union Subordinated Debt, Grandfathered Secondary Capital, and loans or obligations issued by privately insured credit unions that are subordinate to a private insurer. The Board notes that this proposed change will not result in a different risk weighting than the RBC Rule requires. Given that Grandfathered Secondary Capital, Subordinated Debt, and obligations issued by privately insured credit unions that are subordinate to a

private insurer are similar instruments that share similar risks, the Board believes it is appropriate to include them in the same risk weighting category.

3. § 702.109 Prompt Corrective Action for “Critically Undercapitalized” Credit Unions

Section 216(a)(2) of the FCU Act directs the NCUA to take Prompt Corrective Action (PCA) to resolve the problems of credit unions.

The FCU Act indexes various corrective actions to the following five net worth categories:

12 U.S.C. 1790d(a)(2).

• Well Capitalized;

• Adequately Capitalized;

• Undercapitalized;

• Significantly Undercapitalized; and

• Critically Undercapitalized.

Id.

1790d(c).

Credit unions that fail to meet capital measures are subject to increasingly strict limits on their activities. The mandatory and discretionary supervisory actions included in the current RBC Rule aid in accomplishing PCA's purpose and provide a transparent guide of supervisory actions a credit union can expect as its capital declines.

Section 702.109 of the RBC Rule provides for mandatory and discretionary PCA for “Critically Undercapitalized” credit unions. Among the discretionary actions in § 702.109 is one related to secondary capital. Specifically, current § 702.109(b) states that, beginning 60 days after the effective date of classification of a credit union as “Critically Undercapitalized,” the NCUA may prohibit payments of principal, dividends, or interest on the credit union's uninsured secondary capital accounts established after August 7, 2000, except that unpaid dividends or interest shall continue to accrue under the terms of the account to the extent permitted by law.

12 CFR 702.109(b)(11).

The Board is proposing to retain the aforementioned discretionary action for Grandfathered Secondary Capital so as not to impact outstanding secondary capital agreements between LICUs and investors. The Board notes, however, that under this proposal the discretionary action, as discussed above, would be mandatory for Subordinated Debt. With this change, the Board intends to provide investors with certainty. As mentioned in section II. (C)(5) of this preamble, a credit union must disclose this mandatory action to all investors. The Board believes including this as a mandatory action will provide credit unions and investors with clear and transparent regulations regarding the agency's actions in a PCA context regarding Subordinated Debt. The Board notes that the mandatory treatment of this action is also consistent with the OCC's subordinated debt requirements.

Id.

5.47(d)(3)(ii)(B)(

4. § 702.205 Prompt Corrective Action for Uncapitalized New Credit Unions

The Board is proposing to make a technical correction to § 702.205 of the RBC Rule by changing the title of this section from “Mandatory liquidation of uncapitalized New Credit Union” to “Discretionary liquidation of uncapitalized New Credit Union.” The Board notes that the current text of this section states that the NCUA

may

place a New Credit Union into liquidation under section 1787(a)(1)(A) of the FCU Act.

Because the term “may” is discretionary, this proposed change will better align the title of this section with the accompanying text.

12 U.S.C. 1787(a)(1)(A).

5. § 702.206 Revised Business Plans (RBP) for New Credit Unions

The Board is proposing to delete paragraph (d) of § 702.206 of the RBC Rule, which reads as follows:

Consideration of regulatory capital. To minimize possible long-term losses to the NCUSIF while the credit union takes steps to become “Adequately Capitalized”, the NCUA Board shall, in evaluating an RBP under this section, consider the type and amount of any form of regulatory capital which may become established by NCUA regulation, or authorized by state law and recognized by NCUA, which the credit union holds, but which is not included in its net worth.

This section was intended as a placeholder for the eventual creation of a Subordinated Debt rule. As such, the Board is proposing to delete the text in this section and include a new § 702.207 in the RBC Rule related to the consideration of Subordinated Debt for a New Credit Union. The Board addresses this new section in the following section of this preamble.

6. § 702.207 Consideration of Subordinated Debt for New Credit Unions

The Board is proposing a new section that would provide an exception from PCA for a New Credit Union that meets specific conditions related to Subordinated Debt. Specifically, under this section a New Credit Union would not be subject to mandatory and discretionary actions under PCA if the New Credit Union has outstanding Subordinated Debt that would be treated as Regulatory Capital if the credit union were a Complex Credit Union or a LICU. The Board notes that, to qualify for this proposed exception, a New Credit Union would have to have a Net Worth Ratio of at least one percent and issue Subordinated Debt in accordance with the requirements of proposed subpart D.

As discussed in section II. (C)(3) of this preamble, a non-LICU New Credit Union may only issue Subordinated Debt if, at the time of issuance, it has retained earnings of at least one percent of total assets. Further, under this proposal, the NCUA would only consider, for purposes of this exception, the non-discounted portion of any issued Subordinated Debt. Finally, to qualify for this exception, the Board is proposing to require the ratio of the New Credit Union's Net Worth, plus its outstanding Subordinated Debt, to its total assets be at least seven percent.

To avail itself of relief from PCA under this section, a New Credit Union would also be required to increase its Net Worth in a manner consistent with the New Credit Union's approved initial business plan or revised business plan. The Board believes the proposed rule allows a New Credit Union to use Subordinated Debt in a manner that allows the credit union to avoid PCA while maintaining a sufficient buffer between losses and the NCUSIF.

Even if a New Credit Union meets the foregoing criteria, the proposed rule reserves the Board's authority to impose PCA on a New Credit Union in delineated circumstances. These circumstances include where a New Credit Union is operating in an unsafe or unsound manner or has not corrected a material unsafe and unsound condition that it was, or should have been, aware of. However, the Board would only impose PCA in these circumstances after providing a New Credit Union with written notice and opportunity for hearing pursuant to § 747.2003 of the NCUA's regulations.

For FISCUs, the Board is also proposing to include a requirement that the NCUA consult and seek to work cooperatively with the appropriate state supervisory authority (SSA) before invoking the reservation to impose PCA. The Board believes this reservation of rights will allow the NCUA to quickly and appropriately address unsafe or unsound conditions in a New Credit Union, regardless of whether the New Credit Union has issued Subordinated Debt.

In addition, the Board is proposing to prohibit delegation of its authority to take PCA against a New Credit Union that would otherwise qualify for an

exemption from PCA because of its issuance of Subordinated Debt. The Board is proposing to retain such authority because such action could have a direct and material impact to the NCUSIF and the subject New Credit Union. This proposed non-delegation provision is similar to others related to PCA in the RBC Rule.

The Board is also proposing to include in this section a statement that the NCUA will consider any outstanding Subordinated Debt issued by a New Credit Union in evaluating the credit union's revised business plan. Because Subordinated Debt acts as buffer between losses sustained by a credit union and the NCUSIF, the Board believes this change prudently allows New Credit Unions to avail themselves of the benefits of issuing Subordinated Debt while maintaining the safety and soundness of the NCUSIF.

Finally, the Board is proposing to include a provision that allows the Board to liquidate a New Credit Union under section 1787(a)(3)(A) of the FCU Act, provided that a New Credit Union's Net Worth Ratio

plus

outstanding Subordinated Debt that has been issued by that New Credit Union and that counts as Regulatory Capital is, as of the applicable date of determination, below six percent and the New Credit Union has no reasonable prospect of becoming “Adequately Capitalized.” The Board believes it is prudent to include procedures whereby the Board can address a New Credit Union that does not have a reasonable prospect of being “Adequately Capitalized.”

The Board notes that, while Subordinated Debt can be a helpful tool for credit unions to meet their capital requirements, it believes that a credit union's business model should not rely too heavily on the issuance of Subordinated Debt. As such, this proposed provision supports the Board in fulfilling its statutory mandate of protecting the NCUSIF if a credit union has no reasonable prospect of becoming “Adequately Capitalized” without giving effect to any Subordinated Debt issued by that credit union, and is failing to reach even marginal levels of capitalization with Subordinated Debt.

C. Subpart D—Subordinated Debt, Grandfathered Secondary Capital, and Regulatory Capital

1. § 702.401 Purpose and Scope

This proposed section sets out the general purpose of subpart D of part 702. As discussed in more detail below, this section of the proposal also addresses the authority for FISCUs to issue Subordinated Debt and the treatment of Grandfathered Secondary Capital.

With respect to FISCUs, the Board proposes to clarify that the requirements of proposed subpart D of part 702 would apply to FISCUs, but only to the extent FISCUs are permitted by applicable state law or regulation to issue debt securities of the type contemplated by this rule. That is, under this proposal, a FISCU may only issue Subordinated Debt if such issuance is permissible under its applicable state law. To the extent that a FISCU's state law is more restrictive than this proposed rule, the FISCU would be required to follow that state law.

With respect to secondary capital, the Board proposes to address in this section of the proposal both the treatment of outstanding Grandfathered Secondary Capital and the treatment of secondary capital issued in the form of Subordinated Debt after the effective date of a final Subordinated Debt rule.

With respect to any Grandfathered Secondary Capital, the Board is proposing to allow such Grandfathered Secondary Capital to continue to be governed by the regulatory requirements under which it was issued. For ease of reference, the Board is proposing to relocate subsections (b)-(d) and Appendix A of the Current Secondary Capital Rule to a new § 702.414. As discussed in section II. (C)(14) of this preamble, this new section would include all of the requirements in the Current Secondary Capital Rule, but would make clear that LICUs are not permitted to conduct new issuances under proposed § 702.414.

The Board is also proposing to prohibit Grandfathered Secondary Capital from receiving Regulatory Capital treatment as of 20 years from the effective date of a final Subordinated Debt rule. The Board notes that this proposed requirement would prevent Grandfathered Secondary Capital from perpetually receiving such grandfathered treatment. The Board believes 20 years would provide a LICU sufficient time to replace Grandfathered Secondary Capital with Subordinated Debt if such LICU seeks continued Regulatory Capital benefits of Subordinated Debt. The Board believes it is important to strike a balance between transitioning issuers of Grandfathered Secondary Capital to this proposed rule and ensuring that instruments do not indefinitely remain as Grandfathered Secondary Capital. The Board believes the structure of the proposed grandfather provision achieves this balance without unnecessarily disrupting the operations of LICUs, investors, and any outstanding secondary capital agreements.

Finally, the Board is also clarifying that this proposed rule would treat as Subordinated Debt all secondary capital issued after the effective date of a final Subordinated Debt rule. As such, any post-effective date application and/or issuance of secondary capital by a LICU would be subject to the requirements of this rule (except § 702.414, which, as noted above, only applies to Grandfathered Secondary Capital). As discussed above, this change would not alter the ability of a LICU to include Subordinated Debt in its Net Worth, the same way a LICU currently includes secondary capital in its Net Worth.

2. § 702.402 Definitions

This section contains proposed definitions to subpart D of 702. However, subpart D references some terms referenced elsewhere in the regulations. Therefore, for consistency purposes, the Board is proposing to cross-reference definitions of terms found elsewhere in the NCUA's regulations as follows:

83 FR 55467. (Nov. 6, 2018).

80 FR 66625. (Oct. 29, 2015).

Cross-referenced term

Definition

Complex Credit Union

The proposed rule defines the term as having the same meaning as in subpart A of part 702, as amended by the Board on November 6, 2018.

Grandfathered Secondary Capital

The proposed rule defines the term as any subordinated debt issued in accordance with current § 701.34 before [EFFECTIVE DATE OF THE FINAL RULE].

Net Worth

The proposed rule defines the term as having the same meaning as in § 702.2.

Net Worth Ratio

The proposed rule defines the term as having the same meaning as in § 702.2.

New Credit Union

The proposed rule defines the term as having the same meaning as in § 702.201, as amended by the Board on October 29, 2015.

Risk-based Capital (RBC) Ratio

The proposed rule defines the term as having the same meaning as in § 702.2 as amended by the Board on October 29, 2015.

Id.

In addition to the cross-referenced terms, the Board is proposing to define the following terms:

Accredited Investor.

The proposed rule defines “Accredited Investor” as any Natural Person Accredited Investor or any Entity Accredited Investor, as applicable. The Board is aware that the SEC has recently published a proposed rule amending the definition of “accredited investor.” The Board will evaluate any final rule issued by the SEC and make changes to a final Subordinated Debt rule accordingly. Such changes may include substituting specific cross references contained in the definitions of Entity Accredited Investor and Natural Person Accredited Investor with a more general cross reference. In addition, the Board may opt to include a reference to sample accredited investor forms, rather than include such form in the rule, as the Board is proposing to do so in § 702.406 of this proposal.

Appropriate Supervision Office.

The proposed rule defines the term “Appropriate Supervision Office” as, with respect to any credit union, the Regional Office or Office of National Examinations and Supervision that is responsible for supervision of that credit union. By doing so, it provides the Board flexibility in delegating the responsible office, which may change as a reflection of organization changes within the NCUA.

Entity Accredited Investor.

The proposed rule defines the term “Entity Accredited Investor” as an entity that, at the time of offering and sale of Subordinated Debt to that entity, meets the requirements of 17 CFR 230.501(a)(1), (2), (3), (7), or (8), which generally are the requirements applicable to corporate or trust entities and not natural persons.

Immediate Family Member.

The proposed rule defines “Immediate Family Member” as a spouse, child, sibling, parent, grandparent, or grandchild (including stepparents, stepchildren, stepsiblings, and adoptive relationships). The proposed term is intended to be consistent with the definition found in the NCUA's regulations.

Appendix A to 12 CFR part 701, Article XVIII, § 1.

Issuing Credit Union.

For the purposes of this subpart D of part 702, the proposed rule defines “Issuing Credit Union” as a credit union that has issued, or is in the process of issuing, Subordinated Debt or Grandfathered Secondary Capital in accordance with the requirements of this proposed rule. The definition is consistent with the term used by OCC's regulations.

Office of the Comptroller of the Currency, Comptroller's Licensing Manual: Subordinated Debt (2017),

available at https://www.occ.gov/publications-and-resources/publications/comptrollers-licensing-manual/files/licensing-booklet-subordinated-debt.html.

Per the OCC's Comptroller's Licensing Manual for Subordinated Debt, the bank issuing subordinated debt is referred to as the “issuing bank.”

Low-Income Designated Credit Union (LICU).

The proposed rule defines the term “Low-Income Credit Union” as a credit union designated as having low-income status in accordance with § 701.34 of this chapter. This definition is consistent with references to LICUs in the FCU Act as, “a credit union that serves predominantly low-income members.”

12 U.S.C. 1752(5); 1757a(b)(2)(A),); 1757a(c)(2)(B).

Natural Person Accredited Investor.

The proposed rule defines the term “Natural Person Accredited Investor” as a natural person who, at the time of offering and closing of the issuance and sale of Subordinated Debt to that person, meets the requirements of 17 CFR 230.501(a)(5) or (6), which generally are the requirements applicable to natural persons and not corporate or trust entities;

provided

that, for purposes of purchasing or holding any Subordinated Debt Note, this term shall not include any board member or Senior Executive Officer, or any Immediate Family Member of any board member or Senior Executive Officer, of the Issuing Credit Union.

Offering Document.

The proposed rule defines the term “Offering Document” as the document(s) required by proposed § 702.408, including any term sheet, offering memorandum, private placement memorandum, offering circular, or other similar document used to offer and sell Subordinated Debt Notes.

Pro Forma Financial Statements

means projected financial statements that show the effects of proposed transactions as if they actually occurred in a variety of plausible scenarios, including both optimistic and pessimistic assumptions, over measurement horizons that align with the credit union's expected activities. For consistency, this term as defined here is consistent with the

Evaluating Secondary Capital Plans

supervisory guidance issued by the Board on September 16, 2019.

Supervisory Letter No. 19-01, September (Sept. 16, 2019),

available at https://www.ncua.gov/files/supervisory-letters/SL-19-01-evaluating-secondary-capital-plans.pdf.

Qualified Counsel.

The proposed rule defines the term “qualified counsel” as an attorney licensed to practice law in the relevant jurisdiction(s) who has expertise in the areas of federal and state securities laws and debt transactions of the type contemplated by the proposed rule. The Board believes that credit unions need to engage legal counsel that has the requisite experience and expertise to represent the credit union in all aspects of a Subordinated Debt transaction.

Regulatory Capital.

The proposed rule defines the term “Regulatory Capital” as (i) with respect to an Issuing Credit Union that is a LICU and not a Complex Credit Union, the aggregate outstanding principal amount of Subordinated Debt and, until [DATE 20 YEARS AFTER THE EFFECTIVE DATE OF THE FINAL RULE], Grandfathered Secondary Capital that is included in the credit union's Net Worth Ratio; (ii) with respect to an Issuing Credit Union that is a Complex Credit Union and not a LICU, the aggregate outstanding principal amount of Subordinated Debt that is included in the credit union's RBC Ratio; (iii) with respect to an Issuing Credit Union that is both a LICU and a Complex Credit Union, the aggregate outstanding principal amount of Subordinated Debt and, until [DATE 20 YEARS AFTER THE EFFECTIVE DATE OF THE FINAL RULE], Grandfathered Secondary Capital that is included in its Net Worth Ratio and in its RBC Ratio; and (iv) with respect to a New Credit Union, the aggregate outstanding principal amount of Subordinated Debt and, until [DATE 20 YEARS AFTER THE EFFECTIVE DATE OF THE FINAL RULE], Grandfathered Secondary Capital that is considered pursuant to proposed § 702.207. This definition reflects the expanded eligibility of credit unions that may count Subordinated Debt as Regulatory Capital.

Retained Earnings.

The proposed rule defines the term “Retained Earnings” as in U.S. GAAP. The definition is consistent with the FCU Act, which defines Net Worth, in part, as a credit union's Retained Earnings balance under U.S. GAAP.

Additionally, according to section 202 of the FCU Act, a credit union's statement of financial condition is generally to be reported consistent with U.S. GAAP.

12 U.S.C. 1757a(c)(2)(A).

Id.

1782(a)(6)(C)(i). This section of the FCU Act, provides a de minimus exception for following U.S. GAAP for credit unions with assets less than $10,000,000 unless prescribed by the Board or the appropriate SSA.

Senior Executive Officer.

The proposed rule defines the term “Senior Executive Officer” as a credit union's chief executive officer (for example, president or treasurer/manager), any assistant chief executive officer (for example, any assistant president, any vice president or any assistant treasurer/manager) and the chief financial officer (controller). The term Senior Executive Officer also includes employees and contractors of an entity, such as a consulting firm, hired to perform the functions of positions covered by the term Senior Executive Officer. For consistency, this term as defined here is consistent with § 701.14(b)(2) of the NCUA's regulations.

Subordinated Debt.

The proposed rule would define “Subordinated Debt” as an Issuing Credit Union's borrowing that meets the requirements of this proposed rule, including all obligations and contracts related to such borrowing.

Secondary capital issued by LICUs after [EFFECTIVE DATE OF THE FINAL RULE] would be considered Subordinated Debt.

3. § 702.403 Eligibility

Currently, § 701.34 allows only LICUs to issue Secondary Capital. The proposed rule increases the current eligibility beyond LICUs in § 701.34(b) to also include Non-LICU Complex Credit Unions and New Credit Unions. The Board is also proposing to grant eligibility to credit unions that anticipate being designated as a LICU or Non-LICU Complex Credit Union within 24 months following their planned issuance of the Subordinated Debt. The Board believes these proposed changes will allow additional credit unions to issue Subordinated Debt that would count as Regulatory Capital, which could aid these credit unions in complying with the PCA requirements in the FCU Act and the NCUA's regulations.

Under this proposed rule, all eligible credit unions, regardless of designation type, are required to submit an initial application for preapproval under § 702.408 of this section.

LICU Eligibility

Consistent with the FCU Act and the Current Secondary Capital Rule, the Board is proposing to maintain a LICU's authority to seek the NCUA's approval to issue Subordinated Debt. As of June 30, 2019, credit unions with a LICU designation represented 49 percent of all federally insured credit unions with total assets of $628 billion or 41 percent of the total federally insured credit union assets.

Non-LICU Eligibility

For the first time, the Board is proposing that the following categories of non-LICUs would generally be eligible to issue Subordinated Debt:

(1) Complex Credit Unions

Under this proposed rule, a non-LICU Complex Credit Union must have a capital classification of at least “Undercapitalized,” as defined in the NCUA's capital standards,

to be eligible to issue Subordinated Debt. The Board also notes that, under this proposed rule, the aggregate outstanding amount of Subordinated Debt issued by a non-LICU Complex Credit union may not exceed 100 percent of its Net Worth,

as determined at the time of each issuance of Subordinated Debt. The Board is proposing this limit so that the non-LICU Complex Credit Union's regulatory capital is not primarily composed of Subordinated Debt, a lower quality form of capital. This approach is generally consistent with the Tier 1 and Tier 2 capital requirements for banks.

See

12 CFR 702.102.

proposed 702.403(c) of the proposed rule.

(2) New Credit Unions

The Board is proposing that all New Credit Unions, not just those that are a LICU, may be eligible to issue Subordinated Debt pending an NCUA-approved application as described in §§ 702.408 and 702.409. A “New Credit Union” means a federally insured credit union that has been both in operation for less than ten years

and

has $10 million or less in total assets.

For purposes of this proposed rule, a New Credit Union may be a LICU or a non-LICU. The Board is proposing that a non-LICU New Credit Union have Retained Earnings equal to or greater than one percent of total assets to be eligible to issue Subordinated Debt. This provision is included to ensure the non-LICU New Credit Union has some level of loss-absorbing capacity before any deficit in Retained Earnings would be charged against the Subordinated Debt.

12 CFR 702.2.

(3) Credit unions that anticipate becoming a Complex Credit Union or LICU within 24 months of issuance

In certain circumstances, the Board is proposing to extend eligibility for Subordinated Debt issuance to a credit union that does not meet the eligibility criteria currently, but has a reasonable likelihood of doing so in the near future. Under this proposal, an ineligible credit union that can demonstrate through an acceptable pro forma analysis that it is reasonably projected to become eligible within 24 months after issuance (that is, expects to become a non-LICU Complex Credit Union or a LICU within that timeframe) can obtain approval as well. Pro forma analysis should include projections of expected earnings and growth in a variety of plausible scenarios that, at a minimum include the required 24-month measurement horizon. Aspiring credit unions are also subject to the requirements of §§ 702.408 and 702.409 for preapproval and must include in their applications documents to evidence how they will successfully become a LICU (see § 701.34(a) requirements) or a Complex Credit Union within the 24-month period immediately following a planned issuance. The Board is providing this flexibility for aspiring credit unions that may consider Subordinated Debt as a potential source of funding within the required timeframe to support future growth while increasing Regulatory Capital.

FISCU Eligibility

A FISCU's authority to issue Subordinated Debt, if any, is set forth in applicable state law and regulation. Such state laws may be narrower or broader than those for FCUs. However, to the extent a FISCU may issue Subordinated Debt under applicable state law and regulation, it would be bound by proposed § 741.226.

Prohibition on Issuing and Investing in Subordinated Debt

For the reasons discussed in sections II. (A)(1) and II. (B)(3) of this preamble, the Board is proposing to prohibit, except in limited circumstances, a credit union from both issuing and investing in Subordinated Debt.

At the time of issuance of any Subordinated Debt, an Issuing Credit Union may not have any investments, direct or indirect, in Subordinated Debt or Grandfathered Secondary Capital (or any interest therein) of another credit union. If a credit union acquires Subordinated Debt or Grandfathered Secondary Capital in a merger or other consolidation, the Issuing Credit Union may still issue Subordinated Debt, but it may not invest (directly or indirectly) in the Subordinated Debt or Grandfathered Secondary Capital of any other credit union while any Subordinated Debt Notes issued by the Issuing Credit Union remain outstanding.

4. § 702.404 Requirements of the Subordinated Debt and Subordinated Debt Notes

The Current Secondary Capital Rule allows LICUs to issue secondary capital to “non-natural person members and non-natural person nonmembers.”

Under the Current Secondary Capital Rule, a secondary capital account must:

Id.

701.34(b).

• Be in the form of a written contract;

• Be an uninsured, non-share account;

• Have a minimum maturity of five years;

• Not be insured by the NCUSIF;

• Be subordinate to all other claims;

• Not be pledged or provided by the account investor as security on a loan or other obligation with the LICU or any other party;

• Be available to cover operating losses realized by the LICU that exceed its net available reserves, and to the extent funds are so used, the LICU must not restore or replenish the account under any circumstances. Losses must be distributed pro-rata among all Secondary Capital accounts held by the LICU at the time the losses are realized; and

• Be recorded as an equity account entitled uninsured Secondary Capital account.

Subordinated Debt Note Requirements

The Board is proposing changes to the requirements of the Current Secondary Capital Rule. The proposed changes include additional requirements to help ensure the Subordinated Debt Notes are clearly issued as debt, rather than equity, pursuant to the authority in the FCU Act for an FCU to borrow from any source.

Due to the cooperative structure of credit unions, and the members' rights to govern the affairs of them, FCUs do not have the authority to issue equity instruments. Therefore, it is essential for Subordinated Debt issued by FCUs to be considered debt rather than equity.

12 U.S.C. 1757(9).

The Board notes that FISCUs may not be restricted under applicable state law and regulation to issuing only debt instruments. However, the Board is proposing that the debt requirement apply to both FCUs and FISCUs at this time. As insurer, the Board believes that the framework for the types of instruments that would qualify for Regulatory Capital should be consistent for all credit unions. The Board is requesting comments as to whether the NCUA should allow instruments other than debt instruments for FISCUs. If so, what specific instruments, including a detailed description, should be allowed?

Instruments to be considered must be permissible under applicable state law.

As part of the Subordinated Debt Note requirements, the Board is proposing to require that a Subordinated Debt Note be in the form of a written debt agreement. This requirement aligns with requirements in debt transactions of the type contemplated by this rule, which typically require written debt agreements.

Under the proposed rule, Subordinated Debt Notes must, at the time of issuance, have a fixed stated maturity of at least five years but no more than twenty years from issuance. The Current Secondary Capital Rule requires the Secondary Capital account to have a minimum maturity of five years, but does not have a maximum. A minimum maturity of five years is proposed, as it should create sufficient stability and longevity within a credit union's capital base to be available to cover losses. The Board is proposing the maximum maturity of 20 years to help ensure the Subordinated Debt is properly characterized as debt rather than equity. Generally, by its nature, debt has a stated maturity, whereas equity does not. The proposal is consistent with the OCC's subordinated debt regulation for a minimum maturity of five years, although that regulation does not have a maximum.

Because U.S. national banks can issue equity, the distinction of a debt versus equity characterization for subordinated debt under the OCC's regulations is not as critical as it is for FCUs.

12 CFR 5.47(d)(1)(i).

Under proposed § 709.5(b), the Board is proposing that an Issuing Credit Union's Subordinated Debt be subordinate to all other claims in liquidation and have the same payout priority as all other Subordinated Debt, including Grandfathered Secondary Capital issued by the Issuing Credit Union. This proposed provision is substantially similar to the Current Secondary Capital Rule and the OCC's subordinated debt regulations. The FCU Act requires secondary capital accounts to be subordinate to all other claims against the Issuing Credit Union.

Further, the Board is not proposing a separate class for Subordinated Debt issued by non-LICU Complex Credit Unions or non-LICU New Credit Unions at this time.

See

12 U.S.C. 1757a(c)(2)(B)(ii); 1790d(o)(2)(C)(ii).

The Board is proposing that any Subordinated Debt Note must be unsecured. This provision is consistent with the OCC's subordinated debt regulations,

and is not required in the Current Secondary Capital Rule. The Board is proposing this requirement because allowing arrangements that legally or economically secure Subordinated Debt would enhance the seniority of the Subordinated Debt in the event of liquidation of a credit union, which would be contrary to the proposed “subordinate to all other claims” requirement and the FCU Act, as discussed above. Additionally, if the Subordinated Debt Notes were secured by an asset of the Issuing Credit Union, it may interfere with the Issuing Credit Union's operations as it forces the Issuing Credit Union to direct assets or resources to secure the Subordinated Debt Note.

12 CFR 5.47(d)(1)(iv).

The proposed rule also prohibits two specific arrangements which, from an economic standpoint, would effectively act as a security arrangement for Subordinated Debt: (1) A sinking fund,

and (2) a compensating balance or any other funds or assets subject to a legal right of offset, as defined by applicable state law.

These arrangements, in essence, create a secured arrangement from an economic standpoint between the investor and Issuing Credit Union. In the event of the Issuing Credit Union's liquidation, these arrangements would function like collateral and be applied to the obligations of the Subordinated Debt. As a result, the Subordinated Debt Note could, in essence, become senior in right of payment to other credit obligations, thus limiting its ability to absorb losses and protect the NCUSIF.

An example of a sinking fund arrangement is one that would require an FCU to periodically put aside money for the gradual repayment of the subordinated debt.

An example of a compensating balance arrangement is where the investor would require an FCU to maintain a minimum balance in a bank account during the term of the debt.

The Board is proposing that, at the end of each of its fiscal years (or more frequently as determined by the Issuing Credit Union), the Issuing Credit Union must apply its issued Subordinated Debt to cover any deficit in Retained Earnings on a pro rata basis among all holders of the Subordinated Debt and Grandfathered Secondary Capital of the Issuing Credit Union. While this is similar to the Current Secondary Capital Rule, it clarifies the frequency and timing of applying the Subordinated Debt to credit union losses, thus providing more transparency to investors of Subordinated Debt. The current rule is silent on the timing and

frequency of applying Secondary Capital to credit union losses.

The Board is proposing that, except for approved prepayments discussed in sections II. (C)(11) and (12) of this preamble, the Subordinated Debt Note must be payable in full only at maturity. The Board is proposing this new provision to clarify that Subordinated Debt can only be prepaid with prior written approval from the NCUA as discussed in section II. (C)(11) of this preamble. While the Current Secondary Capital Rule does not include this provision, it does require the NCUA's approval to prepay secondary capital that no longer counts towards the credit union's Regulatory Capital.

As such, this provision would not impose additional burden on credit unions.

12 CFR 701.34(d).

The Board is proposing to require disclosure by the Issuing Credit Union of any prepayment penalties or restrictions on prepayment of a Subordinated Debt Note. While the Current Secondary Capital Rule does not contain this restriction, the Board believes this proposed requirement provides additional protection and transparency for Subordinated Debt Note investors.

The Board is proposing changes to the permissible investors for Subordinated Debt. The proposed rule expands a credit union's current authority by allowing Subordinated Debt to be issued to Natural Person Accredited Investors and Entity Accredited Investors, except that no board member or Senior Executive Officer, and no Immediate Family Member of such board member or Senior Executive Officer, of the Issuing Credit Union may purchase or hold any Subordinated Debt Note issued by that Issuing Credit Union.

Under the proposed rule, Accredited Investors would be required to attest to their accredited status using a form that is substantially similar to the form contained in proposed § 702.406(c). This provision helps Issuing Credit Unions with their obligations to limit offers and sales of their Subordinated Debt Notes to qualified Accredited Investors.

Subordinated Debt Restrictions

The restrictions section of the proposed rule adds provisions similar to those found in the OCC's subordinated debt rule,

and also include provisions found in the Current Secondary Capital Rule. In general, these provisions are necessary to avoid undue restrictions on a credit union's authority or ability to manage itself in a safe and sound manner, ensure the Subordinated Debt is characterized as debt in accordance with U.S. GAAP, and prevent agreements that would interfere with the NCUA's supervision of credit unions.

Id.

5.47.

The Board is proposing a restriction that no Subordinated Debt or Subordinated Debt Note be insured by the NCUA. This provision is consistent with the Current Secondary Capital Rule, which requires secondary capital accounts to be uninsured per the FCU Act.

Similarly, the OCC's subordinated debt regulations require that subordinated debt issued by national banks or federal savings associations not be insured by the FDIC.

One benefit of Subordinated Debt that counts as Regulatory Capital is that it acts as a buffer to protect the depositors at a credit union as well as the NCUSIF. To allow Subordinated Debt to be insured by the NCUA would be contrary to this benefit and the payout priorities discussed previously in this section and in section II. (D)(1) of this preamble.

12 U.S.C. 1757a(c)(2)(B)(ii); 1790d(o)(2)(C)(ii).

12 CFR 5.47(d)(ii).

The Board is proposing a restriction that the Subordinated Debt Note not include any express or implied terms that make it senior to any other Subordinated Debt or Grandfathered Secondary Capital. The Current Secondary Capital Rule contains a condition that Secondary Capital accounts are subordinate to all other claims. Similarly, the OCC's subordinated debt regulations require subordinated debt issued by national banks or federal savings associations to be subordinate to all depositors.

The proposed restriction clarifies the Current Secondary Capital Rule's intent by not allowing any express or implied terms that may be contrary to the proposed requirement that Subordinated Debt be subordinate to all other claims as discussed earlier in this section.

Id.

5.47(d)(1).

The Board is proposing a restriction that the issuance of Subordinated Debt may not cause a credit union to exceed the borrowing limit in § 701.38 for FCUs or, for a FISCU, any more restrictive state borrowing limit. While this restriction is not explicit in the Current Secondary Capital Rule, the borrowing limit is not a new regulation and the restriction currently applies to the issuance of secondary capital. The Board is proposing to include this provision to clarify that the borrowing limit does apply to Subordinated Debt issuances as they are considered borrowings for the Issuing Credit Union.

The Board is proposing a new restriction not found in the Current Secondary Capital Rule that the Subordinated Debt Note not provide the investor with any management or voting rights in the Issuing Credit Union. To allow management or voting rights for Subordinated Debt investors would lead to some loss of control of the credit union by the credit union's board. Per the FCU Act, “the management of a Federal credit union shall be by a board of directors, a supervisory committee, and where the bylaws so provide, a credit committee.”

Further, the FCU Act states the board of directors “shall have the general direction and control of the affairs of the Federal credit union.”

Therefore, allowing Subordinated Debt investors to have some control of the Issuing Credit Union would be contrary to requirements of the FCU Act.

12 U.S.C. 1761(a).

Id.

1761b.

The Board is proposing that Subordinated Debt Notes not be eligible to be pledged or provided by the investor as security for a loan from or other obligation owing to the Issuing Credit Union. This provision is consistent with the Current Secondary Capital Rule

and the OCC's subordinated debt regulations.

Allowing such a transaction with the Subordinated Debt Note as collateral would result in the Issuing Credit Union loaning funds to the investor secured by debt owed by the Issuing Credit Union to the investor. As a result, such an arrangement does not provide a risk mitigation benefit to an Issuing Credit Union.

12 CFR 701.34(b)(8).

Id.

5.47(d)(1)(v).

The Board is proposing a restriction that the Subordinated Debt Note may not include any term or condition that would require a credit union to prepay or accelerate payment of principal or interest. This provision is not in the Current Secondary Capital Rule, but is consistent with the OCC's subordinated debt regulations.

The Current Secondary Capital Rule and this proposal both require preapproval to pay Grandfathered Secondary Capital or Subordinated Debt prior to maturity as discussed in section II. (C)(11) of this preamble. Therefore, including such a term or condition in the Subordinated Debt Note may place a credit union in default should the NCUA not approve a request to prepay.

Id.

5.47(d)(1)(vii).

The Board is proposing a restriction that a Subordinated Debt Note not include a term or condition that would trigger an event of default based on the credit union's default on other debts. This provision is not in the Current Secondary Capital Rule and the OCC's subordinated debt regulations do not specifically address this provision. However, the OCC's Comptroller's Licensing Manual for Subordinated Debt

includes an example of a reasonable default trigger as one where the trigger is based on the bank having defaulted on other debts, but it includes a threshold for the amount of defaulted debt, such as a certain percent of capital. The Board is seeking comment on whether it should include a threshold trigger, rather than restrict all defaults based on a credit union's default on other debts (and, if so, what the threshold should be).

Office of the Comptroller of the Currency, Comptroller's Licensing Manual: Subordinated Debt (2017),

available at https://www.occ.gov/publications-and-resources/publications/comptrollers-licensing-manual/files/licensing-booklet-subordinated-debt.html.

The Board is proposing that the terms of a Subordinated Debt Note may not require the credit union to make any form of payment other than in cash. A similar provision is not in the Current Secondary Capital Rule. However, the Board believes this provision is appropriate, as to allow other forms of payment that may not be liquid or may have price volatility (for example, foreign currency) results in an Issuing Credit Union taking on more risk.

Negative Covenant Provisions

Similar to the section above, the Board has added a negative covenants

section. This section includes requirements similar to the OCC's subordinated debt regulations.

Should a credit union agree to such provisions, the NCUA would consider the practice unsafe and unsound, for the reasons discussed below. Further, these provisions, if agreed to, could potentially interfere with the NCUA's supervision of a credit union.

A “negative covenant” is a clause found in loan agreements that prohibits a borrower from an activity.

12 CFR 5.47(d).

The Board is proposing that a Subordinated Debt Note may not contain covenants that require an Issuing Credit Union to maintain a minimum amount of Retained Earnings or other financial performance provision. Although the Current Secondary Capital Rule does not contain this prohibition, this requirement is consistent with the OCC's subordinated debt regulations.

To require a credit union to maintain a minimum amount of Retained Earnings or other financial performance provision could impede the operations of the credit or cause the credit union to take on excessive risk to maintain this requirement and avoid default.

Id.

5.47(d)(2)(i).

The Board proposes to prohibit covenants that unreasonably restrict an Issuing Credit Union's ability to raise capital through issuance of additional Subordinated Debt. This new provision is consistent with the OCC's Subordinated Debt regulations.

The ability to issue Subordinated Debt provides eligible credit unions a long-term, stable source of funding for expansion and the coverage of losses. Therefore, such a covenant could impede operations and the financial well-being of the Issuing Credit Union and would be considered unsafe and unsound.

Id.

5.47(d)(2)(ii).

The Board is proposing prohibiting covenants that provide for default of Subordinated Debt as a result of an Issuing Credit Union's compliance with any law, regulation, or supervisory directive from the NCUA (or SSA, if applicable). The Board believes it is unsafe and unsound to allow such a covenant, as it would hamper the NCUA's or SSA's ability to effectively supervise the credit union or subject the credit union to escalated administrative actions for failure to follow a directive to avoid default on the Subordinated Debt. Further, it could potentially cause monetary fines against the credit union from failure to follow a law or regulation in order to avoid default.

The Board is proposing a new provision which would prohibit covenants that provide for default of the Subordinated Debt as the result of a change in the ownership, management, or organizational structure, or charter of an Issuing Credit Union provided that the Issuing Credit Union or resulting institution, as applicable:

• Following such change, agrees to perform all obligations, terms, and conditions of the Subordinated Debt; and

• At the time of such change, is not in material default of any provision of the Subordinated Debt Note, after giving effect to the applicable cure period of not less than 30 calendar days.

The proposed prohibition is substantially similar to the OCC's subordinated debt regulations.

Change in management or organizational structure or charter of the Issuing Credit Union should have no impact on the Subordinated Debt as it would still be an obligation of the Issuing Credit Union under these circumstances. Further, to allow such a provision would provide a level of control to the investor over the affairs of the Issuing Credit Union. This would be contrary to the proposed Subordinated Debt restriction on allowing the investor with any management or voting rights in the Issuing Credit Union discussed earlier in this section.

12 CFR 5.47(d)(2)(iii).

Additionally, in the case of a merger, as discussed in section II. (C)(12) of the preamble, the Board is proposing that Subordinated Debt can be assumed by the continuing credit union. However, whether the Subordinated Debt counts as Regulatory Capital would still be based on the continuing credit union's eligibility as discussed in section II. (C)(3) of this preamble.

The Board is proposing a new provision that prohibits covenants that provide for default of the Subordinated Debt as the result of an act or omission of any third party. The Board believes that agreeing to such a provision would be unsafe and unsound for an Issuing Credit Union. While credit unions are expected to perform due diligence over third parties utilized, a credit union does not control the acts or omissions of the third parties. As such, it is not a reasonable expectation for the actions of a third party to trigger default or acceleration of payment of the Subordinated Debt.

Default Covenants

The Board is proposing that Subordinated Debt Notes that include default covenants must provide the Issuing Credit Union with a reasonable cure period of not less than 30 calendar days. This new provision provides protection for Issuing Credit Unions by ensuring a reasonable cure period in the event of default. Further, this provision is consistent with the guidance issued by the OCC.

Office of the Comptroller of the Currency, Comptroller's Licensing Manual: Subordinated Debt, 19 (2017),

available at https://www.occ.gov/publications-and-resources/publications/comptrollers-licensing-manual/files/licensing-booklet-subordinated-debt.html

(stating that “a bank should have a reasonable opportunity to cure the default.”).

Minimum Denominations

In order to provide additional protections to purchasers of Subordinated Debt Notes who are Natural Person Accredited Investors, the Board is proposing that Subordinated Debt Notes sold or transferred to Natural Person Accredited Investors be made in

minimum denominations of $100,000. In addition, resales of Subordinated Debt Notes to Natural Person Accredited Investors could only be made in minimum denominations of $10,000. Requiring larger denomination notes, and preventing them from being broken into smaller denominations helps ensure that the purchasers of the Subordinated Debt Notes are sophisticated, high net worth individuals.

The Board notes that an Issuing Credit Union may establish a larger minimum denomination for any issue of Subordinated Debt Notes sold to Natural Person Accredited Investors, as long as any such minimum denominations are adequately disclosed to potential investors and reflected in the related transaction documents. Under the proposed rule, there would be no minimum denomination requirements for Subordinated Debt Notes sold to Entity Accredited Investors because those purchasers are corporate entities who, in the Board's view, are sufficiently sophisticated in financial matters such that the additional protections afforded by large minimum denomination are not necessary.

The Board notes that, since 1995, the OCC has imposed a $250,000 minimum denomination requirement in sales of nonconvertible subordinated debt, which are limited to “accredited investors.” Further, in 1992, the OCC proposed a minimum denomination of $100,000 for such sales, but increased it to $250,000 in the corresponding final rule.

Recognizing the potential for overlap in market participants for Subordinated Debt Notes issued by Issuing Credit Unions and national bank nonconvertible debt instruments, the Board specifically requests comment on whether the NCUA's minimum denomination requirements should correspond with the OCC's requirements. In other words, (a) should the NCUA require minimum denominations of $250,000 in sales of Subordinated Debt Notes to Natural Person Accredited Investors, and (b) should the NCUA impose a minimum denomination requirement on sales of Subordinated Debt Notes to Entity Accredited Investors and, if so, should it be $10,000, $250,000, or a different threshold?

59 FR 54789, 54792 (Nov. 2, 1994).

5. § 702.405 Disclosures

As discussed in section I. (E)(2) of this preamble, the federal securities laws and related SEC rules do not require an issuer of securities to provide any particular level of disclosure to potential investors in securities that are offered, issued, and sold pursuant to most exemptions from the registration requirements of the Securities Act, nor do they mandate the content of any disclosure an issuer chooses to provide. Although the SEC makes it clear that its “anti-fraud” rules apply to all offers and sales of securities, whether registered or exempt from registration, disclosure practices vary widely.

See

17 CFR 230.501(a) (“Users of Regulation D (230.500) should note the following: (a) Regulation D relates to transactions exempted from the registration requirements of section 5 of the Securities Act. . . Such transactions are not exempt from the anti-fraud, civil liability, or other provisions of the federal securities laws.”).

The Board believes that adopting a regulatory framework for the offer, issuance, and sale of Subordinated Debt Notes will benefit both Issuing Credit Unions and investors. Such a framework will provide potential investors information that is important to making a decision to invest in Subordinated Debt Notes of Issuing Credit Unions, and will clearly define the obligations of Issuing Credit Unions. The framework will also clarify various other investment considerations that an Issuing Credit Union should disclose to potential investors before their investment.

The Board further believes this framework will help promote investor confidence, which is particularly important in view of credit unions' relative inexperience offering and selling securities. In addition, the Board believes that the proposed disclosure requirements will reduce the risk of investor claims against an Issuing Credit Union, which will provide at least two key benefits. Reducing investor claims may encourage credit unions concerned with the risks associated with the offer and sale of securities to take advantage of opportunities to raise capital through the sale of Subordinated Debt Notes. It also helps protect the interests of credit union members, as such claims could have an adverse effect on the safety and soundness of an Issuing Credit Union.

The proposed rule requires an Issuing Credit Union to deliver an Offering Document to potential investors in Subordinated Debt Notes and prescribes certain specific disclosures to be made in the Offering Document and in the Subordinated Debt Note itself. Section 702.405 covers the disclosure requirements for the Subordinated Debt Note, while the disclosure requirements for the Offering Document are addressed in § 702.408.

Section 702.405 requires that certain disclosure legends be prominently displayed on the face of the Subordinated Debt Note, and that certain additional disclosures be included elsewhere in the body of the Subordinated Debt Note.

The Board's intention in proposing these requirements is to alert potential investors of a number of important matters regarding an investment in a Subordinated Debt Note. Because the required disclosures are required to be included in the Subordinated Debt Note itself, both initial investors (purchasers of the Subordinated Debt Note directly from the Issuing Credit Union) and persons who subsequently acquire the Subordinated Debt Note will have ready access to the information.

A “legend” is a statement on a security, often noting restrictions on transfer or sale or other material limitations related to the security.

Paragraph (a) of § 702.405 requires that certain disclosure legends be prominently displayed on the face of the Subordinated Debt Note. Some of the required legends identify risks specific to an investment in any Subordinated Debt Notes of Issuing Credit Unions, including the:

• Prohibition on a holder of a Subordinated Debt Note from using the note as collateral for a loan from the Issuing Credit Union;

• Possibility that a portion of, or all of, the principal amount of a Subordinated Debt Note would be reduced to cover any deficit in retained earnings at the end of a credit union's fiscal year (or more frequently, as determined by the Issuing Credit Union), with the result that the amount equal to such reduction would no longer by payable on such Subordinated Debt Note; and

• Prohibition on redemption or prepayment of all or a portion of outstanding Subordinated Debt Notes prior to maturity, other than in limited circumstances involving advance approval of the NCUA or in connection with a voluntary liquidation of the Issuing Credit Union.

Other required legends, such as the requirement to inform investors that the Subordinated Debt Notes are not shares in the Issuing Credit Union and are not insured by the NCUA, are similar to those that are required in offerings of securities by other types of regulated financial institutions. The required legend noting that the issuance and sale of the Subordinated Debt Note are not registered under the Securities Act is intended to alert potential investors that the Subordinated Debt Note does not benefit from all of the protections that are provided by Securities Act registration, and the disclosure legend language identifying the restrictions on

the sale or other transfer of Subordinated Debt Notes by holders informs holders of the notes that they are not freely tradeable, alerting them to the fact that the Subordinated Debt Notes may not be liquid investments supported by an active (or any) secondary trading market.

This last legend combines elements of legends typically included in securities offered, issued and sold in offerings made pursuant to certain exemptions from the registration requirements of the Securities Act and elements that relate to other parts of the proposed rule that are unique to offers and sales of Subordinated Debt Notes, including the prohibition on sales or resales to members of the Issuing Credit Union's board, Senior Executive Officers and/or Immediate Family Members of board members or Senior Executive Officers.

In paragraph (b) of § 702.405, the Board proposes a requirement that an Issuing Credit Union include certain additional disclosures in the body of the Subordinated Debt Note. As is the case with the disclosure legends required by paragraph (a) of § 702.405, the purpose of these disclosures is to inform potential inv

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