Welcome to our fifth issue of Promissory Notes of 2023. Promissory Notes is our Banking & Finance Insights e-newsletter where we highlight important news articles from the industry and explain why they are important.

We are very pleased to introduce you to three new attorneys – Jeremy E. Carroll, Michael W.S. Lockaby, and Julian F. Harf – who have joined our Roanoke team.

Jeremy Carroll is a Member, and his primary areas of practice are local government law, civil litigation, employment law, land use and zoning, school law, government contracts, and public finance. Jeremy also serves as the Lexington City Attorney, Vinton Town Attorney, and Halifax County Attorney.

Mike Lockaby also joins Spilman as a Member, and his primary areas of practice include local government and public entity representation, infrastructure, land use, affordable housing, public finance/bonds, public-private partnerships, and economic development. Additionally, Mike serves as the Botetourt County Attorney and Town of Bedford Attorney.

Julian Harf joins the firm as a Senior Attorney and litigator with an emphasis on the defense of local government entities, public officials, and commercial entities. Julian is a member of the Board of Trustees for the Roanoke County Public Schools Education Foundation and also serves as County Attorney for Bath County.

Thank you for reading.

Bryce J. Hunter - Member; Chair, Tax Credits Practice Group; Chair, Community Banking Group; Co-Chair, Banking and Finance Practice Group; and Editor of Promissory Notes

Joshua L. Jarrell - Member; Chair, Public & Project Finance Practice Group; Co-Chair, Banking and Finance Practice Group

“Lending fraud with small and midsize businesses has increased significantly over the last 12 months, and many financial institutions expect it to get worse, according to a new survey by LexisNexis Risk Solutions.”

Why this is important: Banks, credit unions and digital lenders have all seen an alarming increase in small- and mid-sized business (“SMB”) lending fraud, and many financial institutions expect it to get worse, according to a new survey by LexisNexis Risk Solutions. The survey of lenders found the average year-on-year increase in SMB lending fraud was 14.5 percent, compared to 6.9 percent in 2021. Nearly three in four respondents expect the problem to get worse over the coming year. 

SMB lending fraud losses likely represented as much as 15 percent of overall losses for the institutions surveyed. The average value of SMB lending fraud losses as a percentage of annual revenue was down slightly at 5.5 percent compared to 6.2 percent in 2021, although it remained higher than pre-pandemic levels. The survey noted that SMBs submit more than half of lending applications through online or mobile channels, with a similar proportion of fraud losses attributed to those channels. Still, banks and credit unions reported a small uptick of in-person loan applications and fraud losses as most banks resumed normal in-person operations following the pandemic. Another concerning statistic from the survey indicates that 68 percent of fraud is caught after the point of account origination. Now is the time for lenders to mitigate their loan fraud risk by taking a deep look at their lending compliance procedures and process, especially in the loan application process. --- Bryce J. Hunter

“But, Nicole Elam, the president of the National Bankers Association, said the technology may pose challenges for many small, rural or minority-owned institutions.”

Why this is important: Part of the promise and value proposition for implementing automation into banking is the possibility of increasing ease of access, promoting fairness, and reducing human bias. As consumer demand increases for banking products that promote equal access to financing options, banks are shifting focus to meet the need. While large banks can somewhat readily absorb the upfront costs for investing in that type of infrastructure, small, midsize, and community banks face an uphill climb. Artificial intelligence programming is not immune from bias. As a product of the data fed into the system, it takes time before inherent biases may manifest in an AI protocol, requiring adjustment. In addition, compliance remains an ongoing struggle for automated systems, further limiting the benefit of such an investment for certain institutions. It is critical for smaller and community level banks to embrace the role they share in the overall banking industry. Often, these lenders provide critical financing for a large portion of a local economy, particularly in rural areas. Perhaps fully-automated systems should be limited (or even avoided) when making lending decisions that not only impact the smaller banks’ portfolios, but also directly impact the local community. These can be highly nuanced decisions that require a personal approach, and that is where the smaller and community-level banking institutions shine. --- Brian H. Richardson

“Interim final rule contains updates to reflect a new law and Federal Reserve Board regulation.”

Why this is important: The CFPB issued an interim final rule last month updating its LIBOR transition rule from 2021. The new rule makes changes consistent with the Adjustable Interest Rate Act, or LIBOR Act, enacted in March of last year. The LIBOR Act directed the Federal Reserve Board to identify a replacement index based on the Secured Overnight Financing Rate (“SOFR”) published by the Federal Reserve Bank of New York, including spread adjustments, to replace the 1-month, 3-month, 6-month, and 12-month USD LIBOR indices. The most recent changes include conforming the terminology used to identify the replacement indices and adding an example of a 12-month LIBOR tenor replacement index that meets standards in the Truth in Lending Act. The interim final rule does not modify the CFPB’s 2021 LIBOR transition rule related to the prime rate as a replacement index. According to the CFPB, the updated rule will “further facilitate the orderly transition of those consumer loans that currently use the LIBOR index to other indices” prior to the planned sunset of LIBOR on June 30, 2023. The interim final rule became effective on May 15 and comments are due on or before 30 days after publication in the Federal Register. --- Bryce J. Hunter

“Last week, corporate America had its worst 48-hour stretch of bankruptcies since at least 2008, according to Bloomberg.”

Why this is important: In the United States, there have been at least 230 corporate chapter 11 bankruptcy filings in just the first 150 days of 2023. The numbers are trending upward as companies feel the strain of extended unsustainable debt obligations. With analysts calling back to 2008 in terms of where things are trending, the data are concerning. Retail brands continue to be the hardest hit, which tracks from recent years’ decline. Some well-known brands filing this year include Party City, Tuesday Morning, and Bed Bath & Beyond. If the 2008-2009 cycle is any comparison, corporate bankruptcies are expected to continue to be announced for the next few years. Even after the market decline bottomed out in 2008, the resulting bankruptcy wave continued into 2009 and beyond. Market watchers such as Moody’s Investors Service are forecasting early 2024 for the peak in corporate default for lower credit quality businesses, which could result in a continued trend of corporate bankruptcies. A key difference this cycle will be how the small business markets will respond. This is due to the intervening advent of the subchapter V provisions that make chapter 11 protection more realistic (and affordable) for struggling smaller businesses. --- Brian H. Richardson

“Recent uncertainty among lenders could lead to new challenges for U.S. construction firms as more projects fail to pencil out.”

Why this is important: Economic conditions, including interest rate hikes, point to decreased construction activity in coming months as financing costs for many developers have become prohibitively high. Coupled with these conditions is the recent uncertainty in the banking industry. According to the Associated Builders and Contractors, construction backlog decreased to 8.7 months in March, its lowest level since August 2022. Meanwhile, industry experts, concerned about the long-talked about recession, stress that lending standards for banks have tightened as banking insecurity intensifies causing owners and developers to hold off on projects in the short term. These trends are fueling increased concerns about access to capital in general, and the development of a vicious cycle where lenders charge more to limit their risk, and developers will not or cannot pay higher interest rates to achieve their targeted returns.

Additional factors influencing capital access is the focus on yield from projects and longer lead times for materials. Challenges for project yield (a property’s return after purchasing costs and renovation expenses) are exposed with higher and more limited capital costs and access. On the supply side, longer lead times for materials increase the cost to carry the goods for contractors and developers. Although some materials have become more readily available, the overall supply chain still remains in a fragile state, according to a first quarter CBRE market trends report.

Nevertheless, many industry observers believe that the recent bank failures and corresponding reaction by the Federal Reserve could ultimately force it to put the brakes on interest rate hikes, which may help temper the construction headwinds. --- Bryce J. Hunter