This eUpdate addresses a concern regarding the impact on bank capital of the FASB’s “Proposed Accounting Standards Update, Financial Instruments—Credit Losses (Subtopic 825-15)” (the “Proposal”), should it be adopted.  Specifically, this eUpdate analyzes whether a bank could pass along to borrowers under existing credit facilities any capital charges occurring as a result of the adoption of the Proposal.

The Proposal was issued by the FASB in December of 2012 (with the comment period closing on May 31, 2013).  The current version of the Proposal changes the current loan loss reserve methodology, which only requires loss reserves on loans that have been classified, to a “forward-looking” or prospective methodology that will require a lender to establish loan loss reserves relating to anticipated losses on all loans in its portfolio.1  This modification is being called the “current expected credit loss” or “CECL.”

For banks, this means that as of the effective date of the CECL rule (which is anticipated to be in 20192), a bank’s existing loan portfolio as of that date would have to be analyzed to establish a CECL reserve, which from an accounting perspective would be deducted from a bank’s retained earnings. Importantly, the reduction if incurred would reduce Tier 1 capital for the bank.3

Many banks include in their commercial loan documents “increased costs” and “capital adequacy” provisions that permit the bank to pass on to a borrower any increased cost or capital increase mandated or ordered by a “Governmental Authority” that is deemed to be a “Change in Law.”  The following are the current standard provisions recommended by the Loan Syndications and Trading Association (“LSTA”) on increased costs and capital adequacy:

Change in Law” means the occurrence, after the date of this Agreement, of any of the following: (a) the adoption or taking effect of any law, rule, regulation or treaty, (b) any change in any law, rule, regulation or treaty or in the administration, interpretation, implementation or application thereof by any Governmental Authority or (c) the making or issuance of any request, rule, guideline or directive (whether or not having the force of law) by any Governmental Authority; provided that notwithstanding anything herein to the contrary, (x) the Dodd-Frank Wall Street Reform and Consumer Protection Act and all requests, rules, guidelines or directives thereunder or issued in connection therewith and (y) all requests, rules, guidelines or directives promulgated by the Bank for International Settlements, the Basel Committee on Banking Supervision (or any successor or similar authority) or the United States or foreign regulatory authorities, in each case pursuant to Basel III, shall in each case be deemed to be a “Change in Law”, regardless of the date enacted, adopted or issued. 

Governmental Authority” means the government of the United States of America or any other nation, or of any political subdivision thereof, whether state or local, and any agency, authority, instrumentality, regulatory body, court, central bank or other entity exercising executive, legislative, judicial, taxing, regulatory or administrative powers or functions of or pertaining to government (including any supra-national bodies such as the European Union or the European Central Bank).

Yield Protection

SECTION 1. Increased Costs.

(a) Increased Costs Generally. If any Change in Law shall:

(i) impose, modify or deem applicable any reserve, special deposit, compulsory loan, insurance charge or similar requirement against assets of, deposits with or for the account of, or credit extended or participated in by, any Lender (except any reserve requirement reflected in the Adjusted LIBO Rate) or any Issuing Bank;

(ii) subject any Recipient to any Taxes (other than (A) Indemnified Taxes, (B) Taxes described in clauses (b) through (d) of the definition of Excluded Taxes and (C) Connection Income Taxes) on its loans, loan principal, letters of credit, commitments, or other obligations, or its deposits, reserves, other liabilities or capital attributable thereto; or

(iii) impose on any Lender or any Issuing Bank or the London interbank market any other condition, cost or expense (other than Taxes) affecting this Agreement or Loans made by such Lender or any Letter of Credit or participation therein;

and the result of any of the foregoing shall be to increase the cost to such Lender or such other Recipient of making, converting to, continuing or maintaining any Loan or of maintaining its obligation to make any such Loan, or to increase the cost to such Lender, such Issuing Bank or such other Recipient of participating in, issuing or maintaining any Letter of Credit (or of maintaining its obligation to participate in or to issue any Letter of Credit), or to reduce the amount of any sum received or receivable by such Lender, Issuing Bank or other Recipient hereunder (whether of principal, interest or any other amount) then, upon request of such Lender, Issuing Bank or other Recipient, the Borrower will pay to such Lender, Issuing Bank or other Recipient, as the case may be, such additional amount or amounts as will compensate such Lender, Issuing Bank or other Recipient, as the case may be, for such additional costs incurred or reduction suffered.

(b) Capital Requirements. If any Lender or Issuing Bank determines that any Change in Law affecting such Lender or Issuing Bank or any lending office of such Lender or such Lender’s or Issuing Bank’s holding company, if any, regarding capital or liquidity requirements, has or would have the effect of reducing the rate of return on such Lender’s or Issuing Bank’s capital or on the capital of such Lender’s or Issuing Bank’s holding company, if any, as a consequence of this Agreement, the Commitments of such Lender or the Loans made by, or participations in Letters of Credit or Swingline Loans held by, such Lender, or the Letters of Credit issued by any Issuing Bank, to a level below that which such Lender or Issuing Bank or such Lender’s or Issuing Bank’s holding company could have achieved but for such Change in Law (taking into consideration such Lender’s or Issuing Bank’s policies and the policies of such Lender’s or Issuing Bank’s holding company with respect to capital adequacy), then from time to time the Borrower will pay to such Lender or Issuing Bank, as the case may be, such additional amount or amounts as will compensate such Lender or Issuing Bank or such Lender’s or Issuing Bank’s holding company for any such reduction suffered.

We offer several observations and recommendations:

First, in the case of loans on the books of a bank as of the effective date of any regulatory requirement implementing the Proposal (but originated prior to the effective date of that requirement), the application of the CECL methodology may result in a significant aggregate capital charge.

Second, depending upon the specific language being employed, FASB might not be a “Governmental Authority,” and GAAP might not be considered a “law, rule, regulation or treaty.”  Accordingly, it is possible that borrowers would object to a pass through of a capital or other charge based upon adoption of the Proposal.4

Third, the federal banking agencies require that banks prepare and submit Call Reports and financial reports in accordance with GAAP and use GAAP in determining how such capital is required.5  As a result, the changes in capital requirements that will result from adoption of the Proposal are arguably “a change in...the administration, interpretation, implementation or application...[of a law, rule, regulation or treaty],” but it is not clear—and may invite litigation.6  Among other things, a borrower could argue that any ambiguity should be resolved against the party drafting the language—which in virtually all cases would be the bank as the lender.​7

Accordingly, we suggest that consideration be given to modifying capital adequacy provisions to anticipate the adoption of the Proposal in 2019. This might be accomplished either by expanding the definition of a Governmental Authority and Change in Law or by including a new provision addressing the authority of a lender to recover from a borrower for capital losses resulting from a change in GAAP.

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We trust that this analysis is useful and might assist in determining whether modifications to commercial loan documents should be considered. 

1.   For a comprehensive history of the Proposal and current status, see
2.   We note that it is possible that the federal banking regulators could require that banks begin to comply with the CECL rule earlier than 2019 by utilizing their authority to require “regulatory accounting” that is more restrictive than GAAP.  Such a decision by the banking agencies would lend support to the argument that the CECL rule is being ordered by a Governmental Authority.
3.   The OCC has stated publically that the adoption of the  CECL rule would likely result in an increase in a bank’s loan loss reserve by 30% to 50%, which could result in a significant capital charge to a bank’s Tier 1 capital.  Remarks by Thomas J. Curry, Before the AICPA (September 16, 2013).
4.   While beyond the scope of this eUpdate, we note that the FASB has issued numerous pronouncements disavowing its status as anything except a private organization (and GAAP being merely recommended accounting practices).
5.   The SEC also requires that public companies comply with GAAP in reporting their financial results.
6.   In the preparation of this eUpdate we consulted with representatives of bank trade associations who are responsible for this issue for those organizations—in both cases those staff members were of the view that a modification to GAAP may not constitute a change in law.
7.   We note that banks participating in a syndication or participation loan would be concerned regarding this issue to the same degree as the lead lender or agent.