ILCs Are Back on the Table for Fintechs Seeking Banking Charters

An industrial bank or industrial loan company (each, an ILC) charter is an attractive option for a financial technology company (Fintech) seeking to enter the banking space, and it seems to be back on the table as a viable option for these companies. In March 2020, the FDIC approved two separate de novo deposit insurance applications for Utah-chartered ILCs submitted by Fintech companies Nelnet and Square, respectively, and issued a notice of proposed rulemaking that would require certain conditions and commitments for approval or non-objection to certain filings involving an ILC whose parent company is not subject to consolidated supervision by the Federal Reserve (Covered Parent Company).

As noted in Part II of our series “So, You Want to Be a Bank,” ILCs are state-chartered institutions that may be formed under the laws of certain states, including California, Colorado,  Nevada, and Utah. ILCs are regulated by state banking authorities and the FDIC, and they are empowered to make loans and accept certain types of deposits. As insured depository institutions, ILCs may avail themselves of interest rate exportation under the Federal Deposit Insurance Act. They are also exempt from regulation under most state money transmission laws. These benefits are particularly attractive for Fintechs with lending or payments operations, which are otherwise subject to a hodgepodge of state rules or must conduct business through a bank partnership arrangement.

A company may own an ILC without becoming a bank holding company if the ILC qualifies under an exception in the Bank Holding Company Act of 1956, as amended (BHC Act) for certain ILCs. To qualify, the ILC must be organized in a state which, on March 5, 1987, had in effect or under consideration in its legislature a statute requiring such an institution to obtain FDIC insurance and either (1) must not have assets exceeding $100 million, or (2) must not accept demand deposits. While the limitation on accepting demand deposits is significant, it does not preclude an ILC from providing checking accounts to consumers, since negotiable order of withdrawal accounts — or “NOW accounts” — that provide check writing and other transactional capabilities may be offered to individuals but are not considered demand deposits. Since qualifying ILCs are not “banks” for purposes of the BHC Act, acquiring control of an ILC will not cause the acquiring company to become a bank holding company subject to regulation under the BHC Act, including its limitations on activities and investments.

The ILC exemption from the BHC Act comes with limitations. In particular, any company that directly or indirectly controls an ILC will be considered a “banking entity” subject to the Volcker rule, unless exempted under the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA). The EGRRCPA provides an exemption from the Volcker rule for community banks, which are institutions that do not have, and are not controlled by, a company that hasmore than $10 billion in total consolidated assets, and total trading assets and trading liabilities exceeding 5% of total consolidated assets. Some states may impose additional limitations. For example, a company that directly or indirectly controls a California ILC may only engage in activities that are considered financial in nature.

A provision in the Dodd-Frank Act mandates that U.S. Federal banking regulators require any company that directly or indirectly controls an insured depository institution that is not a subsidiary of a bank holding company or a savings and loan holding company to serve as a source of financial strength for the institution. This requirement means that a controlling investor could be called upon to provide capital support to a subsidiary depository institution, such as an ILC, at a time when it might prefer not to do so.

The ILC charter is also not without controversy. Because it is the only banking charter available to firms engaged in commercial activities not otherwise permissible for bank holding companies and non-grandfathered savings and loan holding companies, it has long been viewed by some as a loophole from the BHC Act. Historically, the charter was used primarily by automobile manufacturers and other commercial and industrial firms to conduct specialty finance operations. But Walmart’s application for an ILC charter in 2005 prompted concern among its competitors, the banking industry, and others that the retailer would unfairly enjoy a competitive advantage by avoiding the regulatory oversight and limitations that normally accompany ownership of a depository institution. The FDIC responded by delaying action on ILC filings and ultimately imposed a moratorium on deposit insurance applications by new ILC charters owned by nonfinancial companies. Until its recent actions, the FDIC had not approved a deposit insurance application for a new ILC charter since 2008, though several applications had been filed and subsequently withdrawn since 2013. The conditions the FDIC imposed on Square and Nelnet, and those it has proposed formalizing as a rule (described below), are similar to those imposed as conditions on other applicants in 2008 with the notable exception that the FDIC has not proposed in its rule limiting the permissible activities of a company that controls an ILC. However, the FDIC’s recent actions do not necessarily resolve the controversy over ILCs, because there is legislation pending in the current Congress introduced by Senator John Kennedy (R-La) that would subject companies that control an ILC to regulation under the BHC Act and preclude commercial firms from acquiring an ILC charter.

As noted, the FDIC’s proposed rule would require certain conditions and commitments for approval or non-objection to certain filings involving a Covered Parent Company. Specifically, the proposed rule would prohibit any ILC from becoming a subsidiary of a Covered Parent Company unless the Covered Parent Company enters into one or more written agreements with the FDIC and its subsidiary ILC requiring that the Covered Parent Company agree to the following:

• Furnish an initial listing, with annual updates, of the Covered Parent Company’s subsidiaries;
• Consent to the examination of the Covered Parent Company and its subsidiaries;
• Submit an annual report on the Covered Parent Company and its subsidiaries, and such other reports as requested;
• Maintain such records as deemed necessary;
• Cause an independent annual audit of each ILC;
• Limit the Covered Parent Company’s representation on the ILC’s board of directors or board of managers, as the case may be, to 25%;
• Maintain the ILC’s capital and liquidity at such levels as deemed appropriate and take such other action to provide the ILC with a resource for additional capital or liquidity;
• Enter into a tax allocation agreement; and
• Depending on the facts and circumstances, provide, adopt, and implement a contingency plan that sets forth strategies for recovery actions and the orderly disposition of the ILC without the need for a receiver or conservator. 

In addition, the proposed rule would require the FDIC’s prior written approval before an ILC that is a subsidiary of a Covered Parent Company may take the following actions:

• Make a material change in its business plan after becoming a subsidiary of a Covered Parent Company;
• Obtain the FDIC’s prior approval to add or replace a member of the board of directors or board of managers or a managing member, as the case may be;
• Add or replace a senior executive officer;
• Employ a senior executive officer who is associated in any manner with an affiliate of the ILC, such as a director, officer, employee, agent, owner, partner or consultant of the Covered Parent Company or a subsidiary thereof; or
• Enter into any contract for material services with the Covered Parent Company or a subsidiary thereof.

The FDIC could, on a case-by-case basis, impose additional restrictions on the Covered Parent Company or its controlling shareholder if circumstances warrant.

As a result, it is essential that any company considering acquiring control of an ILC evaluate the impact of these proposed requirements, and, more importantly, the requirements of any final rule ultimately promulgated by the FDIC, on the company and its investors.

We Can Help You Evaluate Your Organization’s Options

Whether to form or to acquire an ILC is an important decision requiring careful consideration of your organization’s unique activities and needs. Let our team of experienced banking lawyers help you evaluate the structure that best suits your organization, formulate a detailed action plan, and navigate you through its execution. For additional information, please contact one of the authors or another member of Goodwin’s Banking practice, part of its Financial Industry group.