Financial Services Alert - April 23, 2013

Banks that foreclose on real property may be entitled to more favorable tax treatment for the expenses they incur to sell the foreclosure property.  In February 2013, the Internal Revenue Service (“IRS”) Office of Chief Counsel announced that a bank may deduct, rather than capitalize, expenses associated with Other Real Estate Owned, or “OREO” property, in situations where the bank originated the loan and later acquired the property in foreclosure proceedings or by deed-in-lieu of foreclosure.  AM 2013-001 (February 22, 2013), the “February 2013 Memorandum”.  Banks that have traditionally capitalized OREO expenses must file for a change in method of accounting with the IRS in order to deduct those expenses.

Background and Legal Standard:

Section 263A of the Internal Revenue Code requires that if a taxpayer (1) acquires real property for resale and (2) holds the property primarily for sale to customers in the ordinary course of its trade or business, then the taxpayer must capitalize costs associated with the property.  As recently as June 2012, the IRS has maintained that a bank must capitalize OREO property expenses because the bank acquired the OREO property with an intent to resell it.  FAA 20123201F (June 18, 2012).  However, the IRS’ most recent February memorandum concludes that OREO expenses are deductible, because a bank’s sale of OREO property is merely an extension of its primary loan origination activity.  Specifically, a bank does not acquire OREO property in order to resell it for profit, but instead takes title and possession of the property only as a last resort.  In fact, applicable law generally requires a bank to return sales proceeds in excess of the mortgage balance to the borrower.  Thus, the IRS concludes that, because a bank’s sale of OREO property is solely an extension of its lending activity, the bank does not have to capitalize expenses under Code Section 263A.

Although the IRS’ February 2013 Memorandum does not specifically reject prior guidance which requires banks to capitalize OREO expenses, the February 2013 Memorandum does seem to indicate a change in the IRS’ stance, and potentially eligible banks should consider talking with their tax advisors about deducting OREO expenses.

The SEC’s Investor Advisory Committee (the “Committee”) issued a series of recommendations (the “Recommendations”) regarding the SEC’s proposed amendments (the “Proposed Amendments”) to Rule 482 under the Securities Act of 1933 and Rule 34b-1 under the Investment Company Act of 1940 that are designed primarily to provide potential investors with additional information about target date mutual funds (“TDFs”).  (The Proposed Amendments were described in the June 29, 2010 Financial Services Alert.)

Findings.  The Recommendations opened with the following findings:

1. TDFs play an increasingly important role in the retirement savings of American investors.
2. Well-designed TDFs can provide a cost-effective long-term investing solution for the many individual investors who find it difficult to construct and maintain a diversified portfolio with risk levels changing to match their evolving needs.
3. The dramatic drop in value in 2008 of some TDFs that were close to reaching their advertised target date brought new attention to the significant differences in risk levels that exist among funds with identical target dates.
4. Evidence suggests that individual investors are ill-equipped to identify risk disparities among similar seeming funds (including TDFs).
5. Many professional pension fund consultants under-estimate the degree of risk in many TDFs.
6. There is a high degree of concentration among just a few TDFs with the top three fund families having 75 percent of the market share in 2011, and the top ten fund families having 90 percent of the 2011 market share.

The findings include citations to (1) a third-party study sponsored by the SEC regarding investors’ understanding of TDFs and advertisements for TDFs, which was discussed in the March 13, 2012 Financial Services Alert and (2) a study prepared by the staff of the SEC’s Office of Investor Education and Advocacy regarding retail investor financial literacy, which was discussed in the September 11, 2012 Financial Services Alert.

Recommendations.  In broad terms, the Committee recommended that the SEC revise the Proposed Amendments to improve the marketing materials regarding TDFs provided to investors.  The Committee also recommended that the SEC act to ensure that retirement plan consultants receive appropriate information to aid them in deciding which TDFs are included as retirement plan options and offered as default investments.  The Committee also made the following specific recommendations (each accompanied by a supporting rationale):

1. The SEC should develop a glide path illustration for TDFs that is based on a standardized measure of fund risk as either a replacement for or supplement to the asset allocation glide path illustration that is included in the Proposed Amendments.
2. The SEC should adopt a standard methodology or methodologies to be used in both the risk-based and asset allocation glide path illustrations for TDFs.
3. The SEC should require TDF prospectuses to disclose and clearly explain the policies and assumptions used to design and manage TDFs to attain the target risk level over the life of the TDF.
4. The Committee strongly supports the Commission proposal to require TDF marketing materials to include a warning that the fund is not guaranteed and that losses are possible, including at or after the target date; however, the Committee recommended that the SEC consider testing various approaches to providing this disclosure to determine the most effective approach and then mandate that approach in the final rule.
5. The SEC should amend the fee disclosure requirements for TDFs to provide better information about the likely impact of fund fees on total accumulations over the expected holding period of the investment.

SEC Action on the Proposed Amendments.  The comment period for the Proposed Amendments ended almost a year ago, on May 21, 2012.  The SEC has taken no further action on the Proposed Amendments in the interim.

On April 15, 2013 the FDIC filed a complaint in the U.S. District Court for the Western District of Washington against two former senior officers of the failed City Bank, a Washington State-chartered bank (the “Bank”), alleging that the officers breached their fiduciary duties to the Bank and negligently and grossly negligently violated prudent, safe and sound lending practices, FDIC lending regulations and the Bank’s lending policies.  The FDIC alleged that the Bank suffered damages of at least $41 million as a result of the actions of the officers.  The two defendant officers were the former President and the former Executive Vice President/  Construction Loan Department of the Bank.

The FDIC alleges that the Bank operated with a concentration in commercial real estate (and particularly acquisition, development and construction) loans that was far in excess of FDIC regulatory limits and far greater than the levels of such loans maintained by its peer banks.  The FDIC’s complaint emphasizes that the FDIC and the Washington Department of Financial Institutions criticized the Bank for its inadequate loan risk management practices and various other safety and soundness and regulatory weaknesses on as many as six consecutive examination reports.  The FDIC’s complaint alleges that the officers intentionally disregarded FDIC loan regulatory requirements, and the FDIC states in its complaint that

“Rather than exercising caution as they plunged the Bank deeper and deeper into [acquisition, development, and construction] lending, [the officers] instead relied upon informal and autocratic procedures to approve loans.”

The FDIC’s complaint also provides details concerning the relatively high levels of remuneration awarded to the officers as the condition of the Bank deteriorated and describes in detail the specific loans criticized by the FDIC.

FDIC as Receiver for City Bank vs. Conrad D. Hanson and Christopher B. Sheehan, U.S.D.C., W.D. Wash., No. 2:13-CV-00671.