Insider and affiliate transactions subject to more than printed regs

Be petrified of compliance. Compliance is positioned to continue its reign as the sovereign regulatory focus in 2014. Despite only being a few weeks into the New Year, our consulting and law firms are seeing plenty of compliance issues being raised at community banks across the country.

One thing we often stress to our clients is that compliance with all regulations, particularly those related to insider and affiliate transactions, requires looking beyond the “four corners” of the regulation.

The letter of law is obviously paramount, but in many situations the regulators’ internal policy and “guidelines” are more restrictive than the black-and-white regulations.

Unfortunately, compliance in today’s environment means operating according to the regulators’ rules even if those rules prevent a transaction that would ultimately benefit the organization.

Insider transactions and your bank

One compliance issue that we have seen multiple times over the past month is the regulation of insider and affiliate transactions under Regulation O, Regulation W, and Sections 23A and 23B of the Federal Reserve Act. Some of our clients have asked our firms to review specific transactions to ensure regulatory compliance, while other clients have asked that we advise them as to whether certain entities would be considered “affiliates” for purposes of the regulations.

Regulation O limits the amount of credit that a bank can “extend”—that is, loan, offer under a line of credit, or otherwise advance—to any one bank insider. Generally speaking, any extension of credit must be on “arm’s length” terms, within the bank’s legal lending limit, and, if the insider’s aggregate credit increases to more than $500,000, pre-approved by the board of directors.

These requirements also reach extensions of credit to organizations over which one of the bank’s executive officers has control, financial or otherwise, as well as extensions of credit “to the extent that the proceeds . . . are used for the tangible economic benefit of the insider,” including his or her family.

This component is completely up to regulatory interpretation. How is that for all-encompassing?

Affiliate transactions and their regulation

As if the restrictions on extensions of credit to insiders are not broad enough, Regulation W, Section 23A, and Section 23B broadly restrict certain credit transactions with all affiliates.

Under Section 23A, credit transactions with any one affiliate, including transactions to the extent the proceeds are used for the benefit of the affiliate, generally are limited to 10% of the bank’s capital and surplus, and credit transactions with all affiliates are limited to 20% of the bank’s capital and surplus.

Assuming a transaction falls within Section 23A’s capital thresholds, Section 23B further provides that a bank may not engage in the credit transaction unless its terms and underwriting are “substantially the same” as the bank’s comparable credit transactions with non-affiliates.

Interestingly, neither Regulation W nor Section 23A appears to restrict the “benefit” language to a financial benefit, leaving the regulators with significant interpretive leeway.

Avoiding trouble you get into accidentally

On the surface, the regulators’ consideration of indirect benefits to bank insiders and affiliates aligns with the regulations’ general scope and purpose—to restrict certain extensions of credit and benefits to insiders and affiliates that could potentially harm the financial strength of the institution.

In practice, however, the application of the regulations to these indirect benefits creates a number of gray areas that could subject a bank to liability even though it is technically complying with the regulation’s language.

Here’s an example. A community bank came to us because the bank was the lead lender on a participation loan on which several other banks participated, including one of their affiliate banks.

The lead lender came up with a great workout plan for the loan that would have benefited every single participant, including the affiliate and the lead bank. Unfortunately, under the structure proposed, we had to advise them that under Regulation W, 23A, and 23B, we thought it was more probable than not to be an affiliate violation.

Now it becomes a question of, should the bank ask permission or forgiveness? 

The only problem with forgiveness in this situation is that a knowing violation of any of these regulations would likely trigger civil money penalties.

Tough spot for the bank, particularly when the transaction would have benefited all parties.

Armor of conservatism

Simply put, when it comes to complying with Regulation O, Regulation W, and Sections 23A and 23B, the best policy is to take a conservative approach.

It is important to keep in mind that regulatory compliance, particularly in today’s environment, often extends beyond what is written down. We have discussed these issues with the regulators on behalf of our clients numerous times, and treatment can be significantly different depending on the circumstances. In our experience, true compliance often requires taking the extra step to understand the regulators’ interpretation.