Is Your Credit Union Sub-Debt Approved?

Overlooking secondary capital in the subordinated debt (sub-debt) market could put your credit union behind when planned and unplanned investment opportunities arise. Jeff Cardone, Partner/Attorney at Luse Gorman, shares why your credit union may consider getting pre-approved for sub-debt sooner rather than later.


In This Episode

Capital planning is an essential step in helping your credit union grow, remain regulatory-compliant, and seize opportunities as they arise, such as a merger or acquisition. In this episode of “C.U. on the Show,” Doug welcomes guest Jeff Cardone to discuss how accessing secondary capital in the subordinated debt (sub-debt) market can be an attractive option in helping credit unions reach their short- and long-term strategic objectives. They also dive into the approval process, a new rule effective in January, and why a credit union may consider getting pre-approved sooner rather than later.

Jeff, a partner at Luse Gorman, specializes in representing credit unions in merger and acquisition transactions with other credit unions, banks, and fee-based businesses, as well as secondary capital or sub-debt transactions. As Jeff explains, sub-debt is a borrowing alternative with a loan and term structure that gains favorable regulatory capital treatment.

Jeff discusses the offensive and defensive reasons why a credit union may access sub-debt, including pursuing merger or acquisition opportunities, enhancing regulatory capital, and raising liquidity and net worth. With rates currently low, a relatively lengthy pre-approval process, and new rules broadening who can qualify for sub-debt, it’s a great time for credit unions of all sizes to explore this secondary capital market. Listen to the full episode to learn more, such as:

  • The characteristics that make sub-debt unique, and why it’s much more like a security than a traditional loan.
  • What the “Final Rule” is and how it will give more credit unions access to the subordinated market, once only reserved for credit unions with a low-income designation.
  • The timeline credit unions should consider when getting pre-approved and issuing the debt and why credit unions should still think about pursuing pre-approval for “just in time” capital opportunities—even if they’re on the fence.
  • Why credit unions should work with sophisticated counsel and request pre-filing meetings with regulatory agencies before submitting a request.
  • The types of credit unions that may not benefit from sub-debt.

Stream the full episode to learn more.

Learn How Executive Financial Planning Can Benefit Your Credit Union

  • Why you’re probably not realizing the full potential of your benefits and compensation
  • Why it doesn’t cost what you may expect to earn more for retirement
  • Why this missing piece could help you serve your credit union better—and for longer

What does a 125% benefits package look like for you? We’ve seen how it can help transform an executive’s portfolio and offer peace of mind that is priceless in any market.

What is Subscription Financial Planning?

  • Why you’re probably not realizing the full potential of your benefits and compensation
  • Why it doesn’t cost what you may expect to earn more for retirement
  • Why this missing piece could help you serve your credit union better—and for longer

What does a 125% benefits package look like for you? We’ve seen how it can help transform an executive’s portfolio and offer peace of mind that is priceless in any market.

About Doug English CFP®, MBA

Doug English, founder of ACT Advisors, has served senior executives’ personal financial analysis and risk management needs for more than 20 years. He recently launched a podcast, “C.U. on the Show,” where he interviews industry insiders to seek insights credit union leaders can use to drive personal financial success.

Schedule a financial planning demo with Doug to see how our executive planning works. In the session, we’ll discuss what you are looking for in credit union executive financial planning and then screen share our software to demo how the system could work in your circumstances.

Audio Transcription (pulled from the podcast)

Doug 00:00

My guest on today’s podcast is Jeff Cardone, a partner at Luse Gorman. Jeff specializes in helping credit unions and other financial institutions with mergers and acquisitions, executive compensation, employee benefits, and tax planning. In this episode, we discuss subordinated debt including the new rule, the approval process, and why your credit union may want to consider getting preapproved. 

Doug  00:16

Jeff, welcome to the show today. I’m excited to learn about subordinated debt. So, tell us what is subordinated debt? How do credit unions use it?

Jeff Cardone  00:32

Doug, great pleasure to be here. Well, I always like to start when I talk sub-debt, particularly to credit union management teams and boards, what is it in the practical sense, if you’re a credit union? It’s really a borrowing tool. The credit union is borrowing money from investors, but the structure of the loan, the term of the borrowing, is structured in a manner that it gets favorable regulatory capital treatment. I mean, that is, in essence, what sub-debt is. You’re going to find investors that it’s going to be issued to—credit unions borrowed money. Now the typical terms of sub-debt, to get favorable regulatory capital treatment, why credit unions would want to do this, if you’re low-income designated, it’s accretive to your net worth. I mean, that is the beauty of sub-debt. So, when you go out and raise it, and you’re accessing the capital markets, and you get those funds, let’s say you raise $10 million, that immediately enhances your net worth by $10 million. I would say that’s been why this is happening and it’s gotten a lot more attention because the NCUA adopted final rules that are going to go into effect on 1/1/22. And what that Final Rule has done is sort of formalized the sub-debt process. But secondly, it’s brought in the who. We’re going to what, why, and who. Who can issue sub-debt. Currently, it’s only if you’re a low-income designated credit union, you can access the sub-debt markets. That’s been in place since the mid-’90s. What the Final Rule has done is sort of expand the pool of credit unions that can access the sub-debt markets, and what the Final Rule calls them is complex credit unions. And these are credit unions that are $500 million assets or greater. So larger credit unions will now have the ability, even if they don’t have low-income designated status, to access the sub-debt markets as well, starting on 1/1/22. And we can kind of get into the process of that, and so on and so forth. But that’s kind of what’s going on. And one thing I’d add, too, is, and this is also very important, as well, because I get this question a lot, credit union boards will say, well, is sub-debt a sign of weakness, if we have to raise capital via sub-debt? And I would emphasize this: no, absolutely not. I will tell you on the bank side, banks are doing sub-debt hand over fist, and they’re raising capital via sub-debt. And because the rates are so low, it’s been a great market for that. So, absolutely not. I think credit unions can utilize sub-debt, you know, for offensive purposes, whether growing organically or through M&A. They can use it for defensive purposes to enhance their regulatory capital. To provide liquidity for the institutions. There’s a lot of really good reasons as to why credit unions should at least explore this.

Doug  03:26

Interesting. So, with interest rates being at a low point, if you’re locking in a long-term fixed rate of interest, that’s an appealing idea. What are the terms like for sub-debt?

Jeff Cardone  03:39

So, a few requirements to get favorable regulatory capital treatment. Generally, the debt can’t be callable for at least five years. So, in other words, once it’s out there, you’re basically locked in at a minimum of five years before you can redeem the sub-debt. That’s a requirement to get regulatory capital treatment. And typically, the rate is fixed for the first five years, and then thereafter, it kind of converts to a floating rate. And typically, the max term, I think it’s 20 years, in terms of when it can be redeemed. So, generally—you’re locked in for five. And generally, in most of these deals we’ve seen it’s been 10 total, so you’re fixed at five, then it floats for the remaining five. And then the other thing to be mindful of, as you get closer to repayment—the repayment date/the maturity date. Then, you know, if you’re within five years, then at each year thereafter, within the five years, it reduces your regulatory capital by 20% per year. So if you have $10 million outstanding each year, if you’re within five years of the maturity date, you may have the $10 million. But the amount that gets counted as regulatory capital will drop 20% per year. And the reason for that is because you’re approaching the time period where you have to write a check and pay off the debt. Like any borrowing a credit union may have.

Doug  05:06

Is the structure such that it’s sort of like a line? When the sub-debt is issued, you take the capital and then you go from there? Or can you get sort of approved and ready to draw on it if you need it? 

Jeff Cardone  05:27

Well, that’s a great question. So let’s talk a little bit about the process for those who want to do it. So, the way it would work is you have to get pre-approval from your regulator. So, if you’re a federally chartered credit union, it’s going to be the NCUA. If you’re a state-chartered institution, it’s going to be the NCUA plus your state regulator. And you have to get pre-approval before you can issue sub-debt. So you would go in on your application. You have to submit a business plan. What are your plans to use the proceeds? How do you plan to service the debt? The NCUA, the regulators are going to look at it. When you think about how much your debt to equity ratio is, I mean, generally you can’t do more than 100% of your net worth. But you generally don’t want to be above 50% of your net worth as sort of a mark, not saying you couldn’t do that. But that’s kind of a good starting point when you think of the how much. And so you go in on pre-approval, and once you get pre-approved, then under the new rules, you’d have two years to issue the sub-debt. So what we’ve been counseling our clients to do is, you know, if you’re thinking, we probably can use 5 million, maybe you go in for, get pre-approved for 6 or 7 million to give yourself a buffer. Because now you’ve gotten pre-approved for a higher amount, and then you can then go in and then once you get to that point, you could then do it incrementally or you could do it all at once. You just have two years to do it. And then once that two-year period ends, you have to go back in and get pre-approved again with the NCUA and your state regulator. But that’s the typical process. And then what will happen is, once you get pre-approved, you’re going to be working with what they call placement agents. And we have good relationships with placement agents, because you got to find, okay, well, who’s going to buy the debt? Or who’s going to be our investors? So it has to be accredited investors, because this is a securities offering to be exempt from SEC filing requirements. We can’t file with the SEC as a credit union, and so it’s going to be an exempt offering. And typically, the other investors are going to be other credit unions. I mean, there’s sort of the pool of who’s going to actually buy it, but you certainly can have other banks, insurance companies. And so, what placement agents will do is they’ll go out and they’ll actually place the debt, the borrowing. And then we call it “building the book.” So, the credit unions can sort of set the parameters. When you think of pricing of sub-debt, it’s what’s the interest rate going to be? That’s really it. Obviously, the market is going to drive that. But certainly, if the credit union board said look, we’re not going to do sub-debt, we don’t want to pay more than 4%, they can certainly do that. And then it’d be on the placement agents or the investment bankers to go out and sell it. Now they may come back to the credit union and say, well, at 4%, you wanted to raise 10 million, we can only get 5 million at 4%, you have to up it to let’s say 4.5% to get to 10 million. And they can either decide yes or no to proceed. But generally the credit union kind of determines the rules of the road, it’s not a we’ve gotten pre-approved, we have to go out at X percent and sell it. They can set the parameters of the market because it’s an offering. But you have to get pre-cleared by your regulators first.

Doug  08:40

Tell me about the length of time each one of these stages take. I imagine that with a January 22 go date for the $500 million+ credit unions, it’s probably a lot of larger credit unions getting pre-approval right now. Is that right?

Jeff Cardone  09:12

Yes. We have about a half dozen right now that I have filed an application with the NCUA. So the general timeline to do this—figure it’s going to be about a five-month process from start to finish. And you kind of look at various phases of the offering. So, the first month is generally education, learning about what is sub-debt and kind of what we’ve talked about earlier in this discussion. Determining how much we want to raise. What the market interest rates are, and the creditors are thinking: How can we leverage that? You know, if we’re going out and we’re paying 4 or 5% of our capital, can we leverage that? Can we make that accretive to our business? That’s generally like the first month and then the next two months thereafter is putting together your business plan and putting together the application that you’re going to be filing for pre-approval with the NCUA. And again, if you’re state chartered, your state regulator. And then, once that application gets on file, the NCUA takes about 60 days to get back to you. And they’re going to say, yes, you’ve been approved, or they may provide comments and more questions. And then on the legal side, you know, what our role would be is, again because of the Final Rule, and they’ve sort of more formalized the process, as part of the pre-approval application, the credit union will have to create an “investor’s relation policy.” And that’s going to sort of govern things like practical questions like: Okay, once we issue the debt, are we mandated to disclose any information about our financial performance? And you’re not mandated. But you’ve got to cover—what happens if an investor calls another credit union: “Hey, how are you doing this quarter?” You’ve got to be careful, because you can’t have sort of selective disclosures to one institution versus another. I mean, that’s a securities law issue as well. So the policy would be created as part of the pre-approval application. We would create sort of a note purchase agreement and the promissory note—those are sort of the legal documents that are going to effectuate the sub-debt. We’ll also do a little offering circular as well; all this is required by the Final Rule. The offering circular, I like to call that an “I told you so” document. For example, we would have a section there called risk factors, describing the risks associated for an investor, purchasing or investing in sub-debt. And that’s all designed to protect the issuing credit union. So, all that’s going to be part of the pre-approval phase. So then we fast forward, we get pre-approval, and now you start your two year clock to issue the sub-debt. So a lot of the institutions we’re working with now, they’re ready to issue right away. And generally, you’re going to have your placement agent in place, or your investment banker who would insist on placing it, particularly if you’re doing a larger amount, like 10 million+, and then that phase will probably take about three to four weeks. So they’ll go out, they’ll have a potential investor sign NDAs, non-disclosure agreements, then the placement agent will put out what’s called a teaser. Just at a high level—here’s what we’re going out with, here’s the interest rate, general information about the credit union. And then the placement agent will do what’s called “building the book,” and say: Okay, going out, how much can we raise? What are the rates? Once we have that in place, then we have all the investors sign the no purchase agreement, the promissory note, and you close. And so probably, from start to finish, about a five-, six-month process. One thing I’d recommend for credit unions that are sort of on the fence or looking to be strategic is, you have two years to issue. Getting pre-approved is going to take a few months; you might as well get the pre-approval. And then you can always decide, well, let’s issue the debt or let’s not issue the debt. What you really want to try to avoid, we talked about this in our previous discussions, Doug, is “just in time” capital. Because let’s say you find a bank you want to acquire, or a fee-based business, and you need capital to do that. Well, if you start the process, from the beginning, now it’s going to take five to six months, versus if you’ve already gotten pre-approved, now you can get the sub-debt in a matter of weeks. So, I always say, look, maximize the tools in the tool chest, particularly if you’re looking for strategic growth opportunities. And this is certainly one way to do that both for low-income designated credit unions and now these 500 million+ credit unions even if they don’t have that low-income designation.

Doug  13:35

Is there any effect on the credit unions or ratios, reviews, metrics of any kind from being pre-approved? Does it have any effect?

Jeff Cardone  13:46

No, it’s not going to help your capital until you actually issue it. I think it’s helpful, and I know this has come up a lot in M&A transactions we have been involved with. I know banks looking at potential merger partners. And I know credit unions are viewed more favorably if they have the pre-approval and they can access the capital markets. Because now it just strengthens their ability to pay. Because you’re going to have to go in and pro forma, this is certainly going to be a hit to capital when you’re acquiring a bank. And now the credit union has a way to get that capital back, via sub-debt. So, in that regard, it’s very, very helpful from a strategic standpoint.

Doug  14:29

Estimate for me, if you would, costs. We’ve got some timelines, with the pre-approval process going on five months, included in that five months is the time to get the issuance of the capital. And there’s an investment banker involved and that generally doesn’t come cheap. So, give me any ideas of what sort of cost the credit union is looking at?

Jeff Cardone  14:53

Yeah. I would say roughly your total deal cost is going to probably be about 1.5 to 2% of the amount of capital you’re raising. And I know we have some relationships on the business plan side and with placement agents. But generally that’s going to be the typical expense. Now the one benefit from an accounting perspective, and I’ll put my accounting hat on, is that credit unions you could capitalize those costs, and net those costs against the proceeds of the offering. So, it’s not necessarily a P&L expense to the credit union. So that’s a nice benefit, too, because you can roll a lot of that into the proceeds. So if you raised 10 million and your expenses, let’s say, were half a million bucks, then you’re just looking at 9.5 million. It’s not, oh, our non-interest expense went up by 500,000 to do this. It’s a little bit of a process because again, you have to keep in mind, too, this is a securities offering as well. So you’re going to want to have sophisticated counsel, a sophisticated placement agent who’s a registered broker dealer with FINRA, which most investment bankers are. I know, we’ve worked with some credit unions that have worked with advisors who don’t meet that criteria. And you really don’t want to do that. Because, again, the NCUA really emphasizes in their Final Rule that this sub-debt, even though, as I said earlier, it’s a borrowing practically speaking, legally it’s a security. It’s a securities offering. So you just want to be careful. I know the NCUA is going to be very cognizant or really reviewing who the advisors are the credit unions looking at this are using. Which you have to sort of disclose to them in the pre-approval application that will be submitted. That’s an important piece of it as well. That’s why there’s going to be a little bit more cost. 

Doug  15:12

Jeff, have you seen credit unions get turned down for pre-approval?

Jeff Cardone  16:53

So far, no. I have not. But I think the one thing we always recommend is to have pre-filing meetings with your regulators. You want to talk to the NCUA, you want to talk to your state regulator, say, look, here’s what we’re thinking, here’s the amount of sub-debt we want to do. What are your thoughts on that? Not necessarily they’re going  to say yes or no, officially, but they can sort of give you some guidance. Well, I think that’s going to be a little too much. Well that’s going to be not enough. And then also, too, it’s going to be looking at the business plan. You know, why are you doing this? What is the use of the proceeds? How are you going to service the debt, because it’s going to be an added cost. But hopefully, what you’re going to show is, look, we’re going to be able to, even though we’re paying, you know, X percent on this capital, we’re going to be able to leverage that, and it’s actually going to be more accretive to our earnings and enhance our ability to grow. I mean, that’s kind of the story you want to present to the regulators as part of this process.

Doug  17:52

Don’t be surprised. You’re not going to be surprised in getting turned down, because you’ve tested the waters in advance; that makes good sense. Talk to me about the subordinated nature of this capital.

Jeff Cardone  18:07

Yeah, really when this would come into play is, let’s say the credit union liquidated. You’re sort of at the end of the line compared to, let’s say, the members, because they’re going to have a membership interest in the credit union. I mean, because even though it’s debt, it’s got a lot of characteristics as preferred stock. Which is why it gets favorable capital treatment. It’s a purer form of capital than a credit union going out, and saying, hey, I’m going to borrow $5 million from a credit union or a bank down the street. So that’s why it’s subordinated nature. That’s why, for example, it’s not callable for at least five years. That’s why it has to be unsecured. There’s certain requirements that the debt has to meet. If the credit union defaulted on the sub-debt, the borrower or the investor necessarily couldn’t come after them. There’s certain requirements that you have to meet, but it’s really designed to be treated almost like equity rather than debt for regulatory capital purposes.

Doug  19:19

In the credit unions you’ve worked for, or even heard of, are there situations that you can imagine where sub-debt would not make sense?

Jeff Cardone  19:32

One is if your net worth is too low. Because there could be some safety and soundness issues to that. Or, if you don’t have the earnings to support it, I would say maybe sub-debt is not necessarily for you as a credit union. You know, the flipside of that is, if your net worth is quite large, or you have excess capital, sub-debt may or may not make sense for you as well. The other thing to be mindful of with the Final Rule is you cannot be an investor in sub-debt and an issuer. So for a lot of credit unions, let’s say who have like 14-15% net worth, and they’re looking for yield, they’ll love to be an investor in sub-debt. So if you’re a credit union that wants to invest, then you’re not going to have the ability to issue. The NCUA was very strict. They did not want somebody having some sort of reciprocal arrangements where you’re an issuer and you’re a borrower. Banks don’t have that restriction. Credit unions do under the Final Rule.

Doug  20:33

Very interesting. This subject is really new territory, certainly for me, and I imagine for a lot of credit union leaders. Where can our listeners learn more about this subject? And what would you suggest next steps be for interested parties?

Jeff 20:53

Well, I think education is one. Not to be self-serving, but we obviously do a lot, my law firm, we do a ton of sub-debt offerings. I’m always happy to do strategic planning discussions. You know, I have a white paper on the topic. We have relationships with placement agents as well who can have discussions with the credit union. But I always think education is just a good starting point. Understanding what it is. How does it work? What’s the process? How much should we be raising? Start introducing those concepts to boards and management teams. I think that’s a great starting point to kind of get to the next phase. Now we kind of understand it better, we have an idea of how much capital we want to raise, how we’re going to utilize that capital or that sub-debt. Now let’s get to the next phase, let’s start doing it. That’s been a typical process with our clients. There are a lot of planning discussions. And I’m happy to be a resource to any of your credit union audience out there that wants to have discussions about it.

Doug  21:51

Well, as you might know, we’re big fans of white papers at ACT Advisors. We just produced our first white paper. So, I love the idea of sharing that with our listeners. How would they get access to the white paper to begin to learn more about sub-debt?

Jeff Cardone  22:06

Sure, we have a white paper on it that kind of goes into the nuances of the Final Rule and the process. You can email me, my email address is I think, Doug, you have my contact information if your listeners reach out to you. You can go on our website and access it at 

Doug  22:30

www dot L-U-S-E right?

Jeff Cardone  22:35

Yup. We have it posted there. Or just as I said, anybody can send me an email and I’m happy to share it. I will say to the audience out there, in the credit union industry, this is so different and nuanced because it’s a securities offering, there’s not a lot of information out there. But I think our white paper really would be a great starting point for somebody to look at.

Doug  23:06

Thanks so much, Jeff.

Jeff Cardone  23:17

Thank you. Pleasure to be here.


Jeff Cardone and Luse Gorman are not affiliated with or endorsed by ACT Advisors, LLC.