March 16, 2023

Turbulent Banking Sector Renews Interest in Cash Management and Investment Policies

Companies should consider a number of best practices to ensure they manage their cash and investment risks effectively.

Silicon Valley Bank was a leading bank for the tech and life science sectors and for many of the venture capitalists who invest in those sectors. The bank’s abrupt disclosure on Wednesday, March 8, of significant losses on securities sales, and its failure on Friday, March 10, sent shockwaves throughout the venture capital and startup world. Signature Bank’s failure closely followed on Sunday, March 12.

Companies do not always assess the long-term financial viability of the banks that hold their money or provide other critical financial services. Over the last week, countless companies had to grapple with these counterparty risks as they worried about how to make payroll.

Companies, especially startups, often raise significant amounts of capital to fund future operations. Managing cash to ensure liquidity and capital preservation is critical not only to their success but also to their very survival. In this alert, we highlight a number of best practices companies should consider to ensure they manage their cash and investment risk effectively, particularly in this uncertain environment.

Adopt a Cash Management and Investment Policy and Update It Regularly

Companies that have not yet adopted a formal cash management and investment policy should do so immediately. Companies that already have such a policy should review it on a regular basis.

Companies should consult with legal counsel and financial advisors to ensure their policies appropriately address their legal obligations and financial objectives. Policies should be tailored to balance the trade-off between capital preservation and investment returns. This balance will be informed by an assessment of the company’s financial health and the relative volatility of the credit markets and banking sector. For startups, safety of principal and liquidity (i.e., the ability to turn short-term investments into cash) should often trump yield.

Policies should be regularly reviewed by management and discussed with and approved by the board of directors. Financial officers should be mindful of policy parameters and ensure that any modifications undergo appropriate evaluation and are communicated to and approved by the board of directors before implementation.

In addition, the process by which a company reviews and secures management and board approval for a policy can be an important factor enabling it to avoid being inadvertently categorized as an “investment company” — and, therefore, subject to the Investment Company Act of 1940. This issue is of particular concern to many development-stage technology and life science companies that have cash and cash equivalents as a significant portion of their tangible assets. Companies for which research and development expenses constitute a substantial percentage of their total expenses are exempted from the act, provided that the board of directors has adopted a written policy with respect to capital preservation investments, among other requirements.

The adoption of a policy is also of particular concern to venture capital and private equity investors in the context of a financing transaction. These transactions typically result in a substantial cash infusion to relatively nascent organizations, often pre-revenue and thinly staffed, and thus prudent capital preservation is paramount. Investors should consider including in their standard financing documents a closing condition requiring that the target adopt an approved form of policy in connection with the financing (rather than waiting for the matter to be discussed at a future board meeting, if at all) and a covenant requiring proceeds to be invested in accordance with the policy. In addition, venture capital and private equity firms might consider mitigating capital loss by making more tranched investments (that is, investments that are time- or milestone-based).

Maintain Active Banking Relationships with Multiple Banks

A company should evaluate the creditworthiness of the bank (or banks) holding its money or providing other critical financial services. The Federal Deposit Insurance Corporation’s (FDIC’s) standard maximum deposit insurance amount (SMDIA) is $250,000 for deposits held in the same right and capacity at a given bank (see our recent alert for more information about deposit insurance coverage). In the absence of extraordinary measures like those announced on March 12, deposits held in the same right and capacity at a given bank in excess of this amount are not insured by the FDIC. Accordingly, a cash management and investment policy may include bank credit quality requirements, such as minimum credit ratings for long-term unsecured debt or certificates of deposit.

In some cases, it may also be advisable for a policy to encourage diversification of deposits and services among multiple banks. Such diversification may be beneficial for increasing the amount of insured deposits because deposits maintained at separate banks are insured separately. And diversification may also give a company the flexibility to shift at-risk capital.

Loan covenants can complicate a company’s ability to maintain multiple banking relationships. Many lenders, especially venture lenders, require borrowers to maintain most or all of their deposits with the lending bank. Grace periods for breaches of such requirements might be brief. Additionally, loan agreements may impose prepayment or default penalties on borrowers who wish to pay off a loan or move money out of a bank. As a result, borrowers might find themselves “stuck” at a failed bank. In light of recent events, we expect that many companies will push to modify any such existing restrictions, and few will agree to them in future.

Limit the Amount of Capital at Risk in a Bank

As noted above, the FDIC’s SMDIA is $250,000 for deposits held in the same right and capacity at a given bank. Many companies have cash balances that significantly exceed this limit. Although federal authorities took extraordinary measures on March 12 by extending deposit insurance to all deposits held at Silicon Valley Bank and Signature Bank, there is no assurance such relief will be available for other banks. As a result, companies should monitor the amount of cash they have that is subject to risk on a bank-by-bank basis.

The good news is that a variety of cash management strategies are available to help mitigate the risks presented by uninsured deposits. The following are examples, and not recommendations, of strategies that are frequently used by our clients:

  • Consider banking with a bank or credit union that maintains excess deposit insurance. For example, Massachusetts-chartered savings banks and co-operative banks are eligible to offer excess deposit insurance coverage through the Depositors Insurance Fund, which is a private fund that insures all deposits of participating banks in amounts above the FDIC’s $250,000 SMDIA. Together with FDIC insurance, depositors of participating banks enjoy full deposit insurance coverage.
  • Consider deposit placement programs. Many banks offer a sweep program where a deposit in excess of the FDIC’s $250,000 SMDIA (or in excess of another target balance set by the company and bank) is divided into amounts below $250,000 and swept into deposit accounts at other FDIC-insured banks participating in a network. Deposits maintained at separate banks are insured separately, while minimizing the administrative headaches a company would otherwise incur by directly establishing and maintaining accounts at multiple banks.
  • For such arrangements to reduce credit exposure to a company’s bank, the company’s bank must act as an agent and custodian with respect to deposits being placed at other banks, among other criteria. These deposit placement programs rely on the company’s bank and other participants in the arrangement to implement a variety of contractual obligations. In addition, the arrangements take time to put in place. Funds swept out of a company’s bank account and into an account at another bank may not represent deposits at that other bank (they may remain an obligation of the company’s bank) until the funds have left the company’s bank to settle with the receiving bank; this may not occur until the business day following the sweep, and funds may, therefore, be concentrated for a period of time at a settlement bank.

    Additionally, a company should be mindful of other banking relationships it might already have (or will later establish) with banks participating in the network, lest funds swept through the program become aggregated with funds deposited at a receiving bank through other channels. A company will need to identify any banks ineligible to receive the company’s swept deposits.

  • Consider money market mutual fund sweep programs. Many banks offer sweep programs where a deposit in excess of a target balance set by the company and bank is swept into shares of a money market mutual fund selected by a company. When the company’s deposit account drops below the target balance, the company’s bank redeems shares for cash to maintain the target balance.
  • For such an arrangement to reduce credit exposure to a company’s bank, the company’s bank must hold the money market mutual fund shares as the company’s agent and custodian and may not pledge or hypothecate interests in the shares, among other criteria. These money market mutual fund sweep programs also rely on the company’s bank implementing a variety of contractual obligations. Funds swept out of a company’s bank account and into a money market mutual fund may not represent an interest in the fund (and will remain an obligation of the company’s bank) until funds have left the bank to settle the trade with the mutual fund company, which may occur on the business day following the sweep.

    A company considering a money market mutual fund sweep arrangement should be mindful of confusingly similar terminology that relates to a different product. Many banks also offer savings accounts called “money market deposit accounts” or “money market savings accounts.” These accounts represent deposit obligations of a bank and do not represent an interest in a money market mutual fund.

  • Consider using an overnight repo sweep. Many banks offer a sweep program where a deposit in excess of a target balance set by the company and bank is swept out of the company’s deposit account and into government securities overnight. The following morning, funds are generally swept back into the company’s deposit account.
  • In a properly structured and documented repo sweep arrangement, a company should have a perfected interest in government securities at the close of its bank’s business day (and not a deposit obligation of the bank). However, there are important risks to consider. When a bank fails, the FDIC generally respects a bank’s customary cut-off times for purposes of determining end-of-day deposit ledger balances, but the FDIC’s receivership rules empower it to establish an earlier cut-off time (as it apparently did on Friday for Silicon Valley Bank). As a result, a company faces daylight exposure if the bank fails while the funds are on deposit before being swept back into repos at the close of the bank’s business day. There is also operational risk, as a repo sweep transaction might not have been completed before the applicable cut-off time. Funds remaining at the company’s bank that were not invested in government securities before the cut-off time are deposits. In addition to these timing risks, there are a variety of legal requirements that must be satisfied for a repo sweep to work as intended.

  • Interest sweep arrangements do not typically provide additional FDIC-insurance protection. Many banks offer a sweep program where a deposit in excess of a target balance set by the company and bank is swept from a non-interest-bearing deposit account held at the company’s bank into an interest-bearing deposit account held at the company’s bank. Because the destination deposit account is still held at the company’s bank, funds swept into it will be aggregated with the company’s other deposits at the bank for purposes of determining insurability under the FDIC’s $250,000 SMDIA.

If a bank fails, a company might be able to access funds in a sweep arrangement only through the receiver of the failed bank. As a result, the company may not necessarily have immediate access to swept funds. The ability to transfer accessible funds, and the complexity of doing so, are other factors companies should carefully consider.

All of these strategies can be complex and should be carefully vetted. And investments in securities carry their own risks. Before implementation, companies should discuss the suitability and risks associated with these strategies, including carefully reviewing any related documentation, with legal counsel and financial advisors.

Remember to Consider Your Brokerage Relationships

Companies should also be mindful of their brokerage relationships, particularly when their investments, cash, and cash equivalents are held in custody by a bank-owned broker-dealer. For example, it is important to understand where those assets are custodied (in many cases, “carrying” firms have custody, as opposed to the “introducing” broker with which the company has a day-to-day relationship) and to be confident that the custodian is sufficiently capitalized (pursuant to Exchange Act Rule 15c3-1) and compliant with segregation and safeguarding requirements (under the Customer Protection Rule, Exchange Act Rule 15c3-3).

Companies should consider these diligence checks at the beginning of a relationship and also revisit them periodically. Well-run firms are typically pleased to discuss all the positive steps they have taken to promote sound practices in these areas, such as maintaining “EBOC” accounts (i.e., for the “exclusive benefit of customers”). Hesitancy to do so could be a sign of underlying problems at a firm. As we noted for banking relationships, it may also be prudent to mitigate risk by maintaining relationships with multiple broker-dealers, including by diversifying between bank-owned firms and others. Finally, and like FDIC coverage, the Securities Investor Protection Corporation or “SIPC” exists to help restore brokerage customer cash and securities positions held by bankrupt or distressed brokerage firms, protecting each customer up to $500,000 for securities and cash (including a $250,000 limit for cash only).

Be Mindful of Maturities and Stretching for Yield

Given the robust venture financing conditions that existed as recently as a year ago, many companies are holding significant cash balances that may fund operations for several years. It is natural for these companies to seek high yields on cash that might not be needed immediately — but companies should be cautious when seeking high returns, especially in an environment where interest rates are rising rapidly. Companies should consult with their financial advisors before implementing a plan to invest in longer-term or higher-yielding securities.

Pay Attention to Third-Party Risks

As a final note, companies (and their cash management and investment policies) should not ignore third-party risks. In an interconnected world, it can be difficult to isolate such risks, and companies are often exposed to unknown third-party risks, whether as a result of their cloud arrangements, SaaS providers, contract research organizations, or even payroll providers. Last week, many companies realized that their payroll providers also relied on Silicon Valley Bank as their clearing bank. As a result, even if the company had access to sufficient cash to make payroll, their payroll provider was incapacitated. Considering the impact of the failure of a critical service provider’s bank may also be a worthwhile exercise. Payroll providers can, in certain circumstances, obtain “pass-through” FDIC insurance for deposits held at a bank through which funds may be insured on a separate basis for each of the provider’s customers, and companies might consider conducting diligence on their payroll providers to determine whether they have appropriately implemented such arrangements.

To discuss these or other issues in detail, please contact any of the authors of this piece.