Viewpoint: FDIC’s Brokered Deposits FAQs – Implications Range from Limited to Significant for Prepaid Issuers: It All Depends

By John ReVeal and Judie Rinearson, Bryan Cave LLP

Just before heading out of town for the 2014 winter holidays, the FDIC on Dec. 24 released Guidance on Identifying, Accepting, and Reporting Brokered Deposits Frequently Asked Questions (the FAQs), in which it formally stated positions it has been developing over the last few years but had not previously committed to writing.

The implications of the FAQs depend on a number of characteristics of the prepaid issuer; most significantly, its capitalization, risk profile, percentage of brokered deposits and, perhaps, on the types of prepaid cards it issues.

• For well-capitalized FDIC insured depository institutions (collectively, banks) with low risk profiles (specifically a Risk Category 1 rating) and with less than 10 percent of deposits classified as brokered deposits, the implications may be minimal—even including not raising the cost of FDIC insurance premiums.
• For well-capitalized banks with higher risk profiles and/or more than 10 percent of deposits classified as brokered deposits, the FAQs increase the cost of doing business through higher—in some cases significantly higher—FDIC insurance premiums. It is our guess that many prepaid issuers will fall into this category based on their overall profile.
• At the far end of the spectrum, the implications for undercapitalized banks are extremely significant and unfavorable—one could possibly say “career ending.”

As in any complex document, there are some ambiguities in the FAQs and time will tell how those will play out. But, what’s clear is that for many banks, the FAQs raise the cost of doing business, which will (or should) precipitate a review of business models.

Further, banks must consider that the need to reclassify prepaid deposits as brokered may have ramifications beyond their prepaid portfolios per se. For example, reclassification may affect a bank’s contingency funding plan and compliance with the proposed minimum liquidity coverage ratio, if applicable. And, it’s possible that such changes may necessitate amending call reports. Every prepaid issuer must review the FAQs carefully in light of its specific situation and prepaid products and determine its required next steps.

This Viewpoint focuses largely on two areas; (1) the effects of the FAQs on undercapitalized banks and (2) whether it’s possible that some underlying prepaid card deposits are not brokered deposits under the FAQs. We also offer “Possible Courses of Action” below.

Guidance = Rule of Law

Before addressing the legal analysis that explains the implications of the FAQs, we must point out that the FDIC characterizes its publication as “guidance,” but the effect is a rule of law and that law is effective immediately.^[1] This is not guidance a bank can interpret and apply in its judgment; it’s a statement that most prepaid card accounts are now considered brokered deposits, with the attendant ramifications. The FDIC has made it clear that the FAQs are not subject to debate; however, the opportunity may exist to make the case that deposits underlying certain types of prepaid cards do not belong in the brokered deposits category.

The Brokered Deposit Rules and Consequences

Under Section 29 of the Federal Deposit Insurance Act (12 U.S.C. § 1831f) and its implementing regulation at 12 C.F.R. § 337.6, a bank that is only “adequately capitalized” and not “well capitalized” may not accept, renew or roll over any brokered deposit unless it has been granted a waiver by the FDIC. (Our experience has been that such waivers are rarely granted.) Moreover, an “undercapitalized” bank simply may not accept, renew or roll over any brokered deposit, and the FDIC is not authorized by statute to grant waivers.^[2] As a consequence, as soon as a bank suffers economic difficulty, the bank must start shedding its brokered deposits, typically at a time when it most needs those deposits.

Having brokered deposits also can result in an increase in the bank’s FDIC insurance assessments. Banks whose ratio of brokered deposits to other domestic deposits is greater than 10 percent can be subject to up to a 10-basis point increase in insurance assessments, depending on the institution’s size, capital and other risk characteristics.^[3] A bank with a significant prepaid card program, therefore, could find the program to be more expensive than in the past if those accounts are deemed to be brokered deposits.

By regulatory definition, a “brokered deposit” is any deposit obtained, directly or indirectly, from or through the mediation or assistance of a deposit broker. A “deposit broker” includes any person engaged in the business of placing deposits, or facilitating the placement of deposits, of third parties with insured depository institutions, or the business of placing deposits with insured depository institutions for the purpose of selling interests in those deposits to third parties.[4] There are a number of regulatory exceptions to this definition, but the FDIC applies these exceptions very narrowly. Of particular importance here, one exception is for an agent or nominee whose primary purpose is not the placement of funds with depository institution. While one might logically think that this exception would apply to program managers and retailers that sell prepaid cards as part of a general retail business, the FAQs tell us the FDIC disagrees with that view.

The FAQs and Implications for Prepaid

A significant issue raised by the FAQs is that prepaid card accounts, if considered to be brokered deposits, would need to be closed “immediately” upon a bank becoming less than well capitalized. In the past, banks could hope for some relief from the brokered deposit burdens over time because certain deposits would cease to be brokered deposits in some circumstances, such as when a certificate of deposit (CD) matures and is renewed without broker involvement. The FAQs expand the meaning of broker involvement and apply the concept to checking and other accounts in addition to CDs. Those non-CD accounts, apparently including prepaid accounts, are treated under the FAQs as renewing every day, meaning that a bank could be required to close the prepaid accounts on the day after it becomes less than well-capitalized if the FDIC does not provide a waiver.

As noted above, a bank that is not well capitalized cannot accept, renew or roll over any brokered deposit unless the FDIC grants a waiver. Since at least 1992, however, the FDIC has taken the position that a brokered CD is no longer brokered and, therefore, can be renewed, provided it is renewed without any involvement of the original or any other deposit broker.^[5] At that time, the FDIC did not explain what might constitute “involvement,” but some banks were told in recent years that the payment of residual fees to the broker during the term of the account would cause the account to continue to be a brokered deposit.

The FAQs now state that “any type of involvement by the third party will be sufficient to qualify the renewed account as a brokered deposit.” This would include payment of any “renewal fee” to the third party, as well as “the actual holding of the account in the name of the third party (as agent or custodian for the owner or owners)”.^[6]  The irony is that the FDIC itself instructed banks and their program managers to set up prepaid accounts in the name of the third party as agent or custodian to have pass-through insurance, which under the FAQs now causes the accounts to be brokered:

In some cases, in an agency or custodial capacity, the distributor of the access mechanisms (or agent on behalf of the distributor) might open a pooled account for all holders of the access mechanisms. In such cases, the FDIC may provide ‘‘pass-through’’ insurance coverage (i.e., coverage that ‘‘passes through’’ the agent to the holders). See 12 CFR 330.7. Such coverage is not available, however, unless certain requirements are satisfied. First, the account records of the insured depository institution must disclose the existence of the agency or custodial relationship. See 12 CFR 330.5(b)(1). This requirement can be satisfied by opening the account under a title such as the following: ‘‘ABC Company as Custodian for Cardholders.’’^[7]

Another basis for finding “involvement” by the third party is if the broker has “continued access to account information,” such as the balance of the account.^[8]  Since program managers frequently provide customer service including responding to cardholders’ balance inquiry requests, this too directly affects many prepaid card programs.

To the extent that prepaid accounts held by a bank that uses a program manager are brokered deposits, it would seem likely that those accounts would continue to be brokered deposits for all time under many such programs. We believe that some program managers do hold the funds in their name as agent or custodian for the cardholders, and many program managers participate in the processing of these accounts and, therefore, know account balances at all times.

This particular FAQ might be construed as applying only to CDs, given that one ordinarily thinks of renewals or rollovers occurring only for CDs. Another FAQ, however, states that a bank that ceases to be well capitalized must immediately close brokered deposit accounts that never mature or renew (such as an interest bearing checking or savings account).^[9] Unlike CDs that have a fixed maturity date and cannot be closed without an early withdrawal penalty, checking and regular savings accounts allow daily withdrawals and can be closed at any time. Implicitly, therefore, the FDIC is stating that these checking and non-CD savings accounts renew every day for purpose of the brokered deposit regulation, thus triggering the rule that a bank that is not well-capitalized cannot “renew” any brokered deposit.^[10] This theory would seem to apply equally to prepaid card accounts, since they, too, can be closed at any time by the consumer.

Accordingly, if the prepaid program is structured such that a program manager or retailer is a deposit broker, those accounts would need to be closed immediately upon the bank becoming less than well capitalized. The only exceptions would be if the program manager has no involvement whatsoever with the accounts after they are opened, which we expect will very rarely be the case, or unless the bank is adequately capitalized and receives a rare waiver from the FDIC.

The definition of deposit broker includes those persons in the business of “facilitating the placement of deposits,” as noted above. In 1992, the FDIC latched on to this phrase and asserted that in “common usage” facilitate means “to make easy or less difficult.”^[11] This approach gave the FDIC all it would need in the future to declare any deposit-related activity to be deposit brokerage, unless a clear regulatory exception would apply.

The FAQs indicate an even broader approach by the FDIC to defining “facilitate.” The FDIC notes that the definition of deposit broker is “very broad” and “facilitating” is “interpreted broadly” to include actions “to connect” banks with potential depositors.^[12] “Any actions that connect” a bank with potential depositors may be considered as facilitating the placement of deposits.^[13]

For example, marketing companies that receive volume-based fees are defined as deposit brokers in the FAQs because they connect the bank with new account holders.^[14] Likewise, companies that design deposit products for banks are not necessarily deposit brokers, but they would be deposit brokers if they also market the products in exchange for volume-based fees.^[15] At the same time, the absence of fees or other direct compensation does not necessarily change the conclusion, depending on other factors.^[16]

On the basis of these FAQs alone, it appears that the FDIC could readily treat many or most prepaid program managers as deposit brokers. Program managers often assist the bank in designing the products. They also often assist the bank in establishing contracts with retail establishments to sell the cards, thus arguably providing a form of marketing. And, many program managers provide marketing materials or otherwise market the products to consumers. Because a program manager might naturally be compensated based on the number of prepaid accounts because the volume of accounts corresponds to the volume of work needed to manage those accounts, these facts taken together could provide a basis for the FDIC to conclude that the program manager is connecting depositors with banks for a fee, thus “facilitating the placement of deposits.”

The FAQs also indicate that the sales of prepaid accounts through any third-party retailer would cause the accounts to be brokered deposits. The retailers are “connecting” the depositor with the bank, and retailers are generally paid a fee or commission for each card that they sell, thus operating under a volume-based fee scheme.

As if this is not troubling enough, the employer providing a payroll card program could be said to be “connecting” its employees with the bank as depositors. Although such employers might rarely be compensated by the bank for the accounts, the FAQs and prior FDIC Interpretive Letters state the FDIC’s view that this is not necessarily dispositive to the brokered deposit question.^[17]

HSAs present the same concerns. When an employer or health insurer offers a high-deductible health insurance plan, that employer or insurer typically will refer the consumer to a bank that will establish the HSA. The employer or insurer might even provide the consumer with the bank’s account application or marketing materials. Clearly the employer or insurer in these cases is “connecting” the customer with the bank. This in itself could cause the accounts to be brokered deposits under the FAQs. Some of these companies might also have their own deposit or loan arrangements with the bank, perhaps at favorable rates for referring customers to the bank for HSAs, making it even more likely that the FDIC would treat the accounts as brokered deposits.

Are There Any Useful Exceptions?

Given the negative implications of the FAQs for prepaid accounts, payroll accounts and HSAs, the question is whether there are any strong bases to argue that the accounts are not brokered deposits. As we discussed above, there are certain exceptions to the definition of deposit broker. Almost all of these exceptions would be inapplicable to a typical bank’s prepaid card program.

The one exception that might, at first, seem applicable is for an “agent or nominee whose primary

purpose is not the placement of funds with depository institutions.” The FDIC, however, has historically interpreted this exception very narrowly,^[18] considering whether there is any “substantial purpose” for the program other than the placement of funds in deposit accounts or obtaining deposit insurance.^[19] If the FDIC cannot be persuaded that there is a substantial purpose for the program other than the placing of deposits, the accounts established through the program will be brokered deposits if they are generated through the activities of a third party.

The FAQs continue this trend to the disadvantage of the prepaid industry. While the plain meaning of “substantial purpose” would appear to open the door for the vast range of other substantial purposes served by prepaid card programs (providing access to financial services for the unbanked: replacing paper checks and reducing costs to businesses and governments; offering an inexpensive and convenient means to pay employees) the FDIC has taken a hard line, with minimal explanation. The FAQs state that the primary purpose exception generally will not apply to companies that distribute prepaid cards that provide access to funds at banks.^[20]

While this FAQ stated that the result would depend on the circumstances, it is unclear what circumstances would lead to a more favorable result, particularly in view of the next FAQ that states that the primary purpose exception will not apply to retail stores or other venues that sell prepaid cards to members of the public.^[21] This FAQ is somewhat ambiguous, so is worth quoting in full for further discussion:

E8. Does the primary purpose exception apply to companies that sell or distribute general purpose prepaid cards?

No. Some companies operate general purpose prepaid card programs, in which prepaid cards are sold to members of the public at retail stores or other venues. After collecting funds from the cardholders, the retail store or the card company (as agent for the cardholders) may place the funds into a custodial account at an insured depository institution. The funds may be accessed by the cardholders through the use of their cards.

The retail stores and the card companies that sell or distribute general purpose prepaid cards (or similar products) are not covered by the primary purpose exception. Rather, in placing the cardholders’ funds into custodial accounts at insured depository institutions, such companies (or the retail stores that may be involved in the placement of the deposits) qualify as deposit brokers. Therefore, the funds qualify as brokered deposits.

This FAQ seems to reflect a misunderstanding by the FDIC of how prepaid card programs function when cards are sold by retailers. The FAQ suggests that the retailer is sending the funds from sales directly to custodial accounts for the cardholders. We believe, more commonly, that retailers send funds to a reserve or other account at the bank, and the bank then moves the funds to the pooled cardholder accounts. Whether this distinction would make any difference to the FDIC given its obvious aim to apply the brokered deposit rules to the prepaid card industry is unclear, but it is at least worth pursuing with the FDIC.

In fact, we would argue that there is ample room for the FDIC to conclude that retailers that sell any number of issuer’s prepaid cards are not doing so for the substantial purpose of placing deposits or facilitating the placement of deposits. Their primary purpose is only to sell products at retail, some of which happen to be prepaid cards. Also, as a policy matter, none of the presumed horrors of brokered deposits seem applicable here. There is no reason to assume that prepaid accounts sold through retailers are any more volatile than those sold directly from bank branches or on the bank’s Website. There is no reason to believe that banks that sell prepaid cards through retailers are necessarily more inclined to use the funds for risky loans or investments, compared to banks that sell the accounts directly. If anything, the retail sale mechanism allows a bank to provide the cards in a more cost-effective manner than doing so through its branches, where more employees will be required to handle the volume, or through its Website, where more costs are incurred to develop and maintain the site.

As for program managers, based on our observations from regulatory examinations, the FDIC has long been suspicious of the role of program managers, fearing that program managers pose a “rent-a-bank” threat to depository institutions. These FAQs appear to represent a new way for the FDIC to discourage the use of program managers.

Possible Courses of Action

Nevertheless, factors that might help to persuade the FDIC in individual cases that the program manager is not a deposit broker might include:

1. Instead of holding pooled funds in a custodial account under the program manager’s name, have the bank hold the pooled funds in a bank-owned custodial account.
2. Clear contractual provisions demonstrating the bank’s ownership of the prepaid accounts and related customer relationships, both during the term of the contract and in the event of termination of the contract. If the program manager has the ability to “move” the account relationships to another bank under any circumstances, this could signal “volatility” to the FDIC and make it less inclined to treat the program manager as other than a deposit broker.
3. Contractual provisions that demonstrate that the program manager’s fees from the bank are tied to specific services relating to the accounts other than facilitating the placement of deposits. For example, clearly outlined duties for processing of accounts, handling customer communications, and assisting with customer dispute resolution can make it clear that the program manager is just a traditional bank vendor and not a deposit broker.
4. If the program manager assists with marketing functions, compensation should not be tied to success but should be a flat fee for specified marketing functions. In this way, the marketing fees would more closely track the fees that all companies pay to newspapers and other mass media outlets for placing of advertisements.
5. To the extent the program manager has a role in identifying retailers that would sell the cards, the contractual arrangement should be between the bank and the retailer, and not the program manager and the retailer. This, again, more clearly reflects that the program is the bank’s program and the bank’s control over the program.
6. Program manager contracts should not tie program manager compensation to the success of the program. Service level requirements under which a program manager could be penalized for failure to meet the requirements, such as a failure to respond to all customer inquiries within a specified time, should be acceptable because that would be common for any customer service vendor. In contrast, compensation that is based on a percentage of customer fee income or average balances may provide a basis for the FDIC to conclude that the program manager is incentivized to establish more accounts, thus causing the manager to look more like a deposit broker.

Unfortunately, it is not clear at this time that any of these factors together or individually would save the day, and, perhaps, there are likely other steps that the industry can take to strengthen the case that at least some program managers are not deposit brokers. We are hopeful that industry conversations with the FDIC will provide a path to a continuing, robust prepaid card program that is not hobbled by brokered deposit implications.

We are somewhat more optimistic that the FDIC might apply the primary purpose exception to payroll cards, government benefit cards and HSAs, given the obvious public policy implications of a contrary decision. The employer’s primary purpose is finding a cost-effective way to distribute salary and commissions to its employees, not to establish deposit accounts or place funds. Even if the employer is suggesting specified banks or providing its employees bank account applications, this should not undermine the primary purpose exception. Similarly, a state or federal government agency is also not seeking to place deposits in banks. As with employers, they merely are looking for a cost-effective manner to distribute benefits to citizens. There are and likely will be a limited number of banks that will issue either payroll or government benefit cards. Those banks that issue payroll cards, in particular, will need to perform due diligence on the employers before linking their cards and reputation to the employer, and this necessarily will mean that individual employers will have limited options for banks.^[22]

Likewise, an employer or insurance company offering an HSA option is not doing so for the primary purpose of placing deposits. The company is offering the HSAs only as part of and for the purpose of providing a high-deductible health insurance plan to the consumer.

Conclusion

Like so much in prepaid, how the FAQs will affect a particular issuer and its prepaid business “depends”—in this case on your capitalization, your risk profile, the percentage of brokered deposits you hold and the types of prepaid products you offer. And, only you, along with your counsel and financial officers, can make that determination. At the risk of wagging our finger like a schoolmarm, we’ll point out the obvious that it’s incumbent on you to conduct the self-analysis to determine the FAQs’ implications on your shop and then chart a path to do what’s necessary. Of course, one of the key necessities goes beyond the pure prepaid environment; it’s ensuring that your bank is well capitalized and that you’re effectively managing your risk profile. The FAQs are the law of the land and unless there’s a miraculous breakthrough at the FDIC, they are a new part of the reality that must be incorporated into the prepaid landscape.

Although the FAQs were issued three weeks ago, they’re just now being examined throughout the industry, and we’re all still learning. If you have more to add or you disagree with what we’re saying, let us know. We learn from each other.

John ReVeal and Judith Rinearson, who lead Bryan Cave’s payments group, are partners in the firm’s Washington, D.C., and New York City offices, respectively. They also are contributing editors to Paybefore and frequent contributors to and resources for Pay Gov. John and Judith may be reached at [email protected]  and [email protected].