RALEIGH, N.C. – The $12 billion State Employees CU of N.C. has received a private letter ruling from the IRS that CEO Jim Blaine hopes will pave the way for alternative capital to be incorporated in prompt corrective action, remove the capital excuse from CUs converting to banks, and also put to rest fears that alternative capital would hurt the tax exemption. While Blaine is optimistic, not all are convinced the ruling has a wide enough scope to make a significant impact. In 2001, Blaine's CU issued $1 million in what it calls "equity shares" to community development CU Self-Help CU in Durham, N.C. "Basically we said, `you give us a million, we owe you a million and we'll pay you a dividend rate comparable to the Federal Home Loan bank of Atlanta'. We picked them because they're a co-op and they issue supplemental capital," said Blaine. The equity shares were approved by the CU's auditors, the state regulator and NCUA, but of course did not meet requirements to be used for PCA. Also, since the shares were to a member and not an outside party, it limits the scope of how this letter can be interpreted. Blaine echoed what he's said so many times before. Corporates, low-income CUs, and banks can all utilize supplemental capital, so why not CUs? "Natural person credit unions are the only ones who can't, it doesn't make sense. If you have this huge influx of deposits you should be able to go to the market and get capital temporarily. It makes everything safer and sounder," said Blaine. SECU's equity shares came with no voting rights and were not guaranteed. According to the IRS letter, the CU's issuance to Self-Help was not capital stock and thus would not affect the tax exemption. ".we conclude that Equity Shares do not constitute capital stock within the meaning of section 501(c)(14)(A) of the Code because they are merely a means of saving in that they grant neither a participating equity interest in Credit Union nor any participation in the management of Credit Union," the IRS wrote. CUNA EVP and General Counsel Eric Richard said the ruling does show credit unions have some flexibility in structuring investments to raise new capital, but noted it's a "fairly narrow ruling." "It did not have the characteristics of a marketable security, and can't be traded for a higher price. As the IRS said, it was essentially a saving vehicle. I read this opinion as the IRS saying there is great flexibility within the membership," said Richard. This isn't all bad however. With more CUs serving businesses, they could attract thriving businesses to these issuances. Richard said once you go to the outside world, the issue of voting rights becomes more of a problem. "With an outside party, you have lots of rights to consider," he said. Blaine said CUs could use SEC guidelines to structure them for outside investors. "Look to SEC definitions of who can qualify for what. All this stuff is not new. Institutions have been doing this for years," said Blaine. Richard, however, said it might be hard to attract outside investors who have lots of high-yielding marketable security options. Blaine said the CU may find a good market within the membership. He maintains that at many CUs, as is the case with SECU, roughly 15% of deposits are uninsured because they are in accounts over $100,000, typically IRAs and longer term accounts. These members could be called on for equity shares. "They're already at risk. You can give them a better return," said Blaine. Richard, a seasoned lawyer, said this letter can only be a positive however in that it gives CUs a window into the mindset of the IRS and there could be some very creative ways to build from on this ruling. But he also noted that of course the letter only applies to this specific situation at SECU and is not precedent setting. Richard Garabedian, an attorney who specializes in assisting CUs converting to banks, said Blaine's experiment, given it was issued to a CU, carries inherent risk. "Allowing credit unions to count as capital secondary instruments issued to other credit unions does not transfer the risk outside the NCUSIF system and I doubt any final congressional or regulatory action would allow that. It is not permitted for FDIC insured institutions," he said. NASCUS EVP of Government Relations Sandra Troutman said NASCUS believes the letter makes a statement. "It's a step to the realization that alternative capital is a safe and sound option for credit unions and a valid way to build net worth," she said. Troutman said whether if it's with a member or not, she doesn't think the structure would have to change and parties would still understand the risk. NASCUS has long supported capital reform, including risk-based capital and alternative capital. This letter is timely given all the talk about PCA reform. Nick Owens, special assistant to NCUA Chairman JoAnn Johnson, said the chairman is open to alternative capital, but believes risk-based capital must first be in place. "Chairman Johnson believes a risk-based capital structure is the most comprehensive approach to improving the system for credit unions, and she is encouraging Congress to act favorably on the legislative proposals to authorize a risk-based capital system. Should Congress also choose to authorize secondary capital for credit unions, NCUA would certainly be pleased to implement such a program, incorporating into a risk based capital system, with a primary focus on safety and soundness and protecting the integrity of the credit union system," said Owens. [email protected]