I.INTRODUCTION Regulation O governs “extensions of credit” to “insiders” (e.g.,directors, executive officers, principal shareholders as well as their related interests). Believing that insider lending plays a major role in bank failures, Congress passed the FDIC Improvement Act of 1991 (FDICIA), significantly changing the laws affecting such loans. Since enactment, the Federal Reserve Board (FRB) regulations extend loans to insiders restrictions to bank directors and limit the aggregate amount of credit that a bank may extend to its insiders as a group. The FDIC amended its regulations to subject state-chartered non-member banks to many Regulation O provisions, effective May 18, 1992. Regulation O is found at 12 C.F.R. Part 215 of FRB regulations which are cited in this article, unless otherwise noted. II.DEFINITIONS To better understand the complexities of Regulation O, a review of the following definitions may be helpful: Affiliate– any company of which a bank is a subsidiary (e.g., bank holding company) or any other subsidiary of that company. Company– any corporation, partnership, trust, association, joint venture, pool syndicate, sole proprietorship, unincorporated organization orany other form of business entity, excluding either an insured depository institution or a corporation in which the majority of shares are owned by the United States or any state. Control– “Control of a company or bank” means a person who directly or indirectly, or acting through or in concert with one or more persons: (1) owns, controls or has power to vote 25% or more of any class of voting securities of the company or bank; (2) controls the election of a majority of bank or company directors; or (3) has the power to exercise controlling influence over management or policies of the company or bank. An individual is not considered having control, including the power to exercise a controlling influence over the management or polices of a company or bank only because of that individual’s position as officer or director of a company or bank; however, apresumption of controlarises if a person is: (1) an executive officer or director of the holding company or bank and directly or indirectly owns, controls or has the power to vote more than 10% of any class of voting securities of the holding company or bank; or (2) the person directly or indirectly owns, controls or has the power to vote more than 10% of any class of voting securities of the holding company or bank and no other person owns, controls or has the power to vote a greater percentage of that class of voting securities. This presumption may be rebutted by submitting to the appropriate federal banking agency, written materials that, in the agency’s judgment, demonstrate an absence of control. Director– any director of the bank, director of a bank holding company of which the bank is asubsidiary or any other subsidiary of the bank holding company, whether compensated or not, but does not include advisory directors who: are not elected by the shareholders of the company or bank; are not authorized to vote on matters before the board of directors; and only provide “general policy advice” to the board of directors. NOTE: An extension of credit to a director of an affiliate bank or company within the same holding company organization is not subject to lending restrictions found in §§ 215.4, 215.6 and 215.8 (See, below) if: the bank has excluded the director of the affiliate from participation in major policymaking functions of the bank (and the individual does not actually participate in such functions); the affiliate is not the bank’s parent holding company; the affiliate’s assets are not greater that 10% of the consolidated assets of the holding company that controls both the bank and the affiliate; and the individual is not otherwise subject to Regulation O (e.g., if the individual is also a principal shareholder, there is no exemption). To exclude a director of an affiliate, a resolution of the board of directors or a corporate bylaw may either include the director (by name or by title) in a list of persons excluded from participation in major policymaking functions or not include the director in a list of persons authorized (by name or by title) to participate in such functions. Executive Officer– any person who participates or who has authority to participate (other than in the capacity as a director) in major policymaking functions of the company (Note: an executive officer of a bank holding company of which the bank is a subsidiary or of any other subsidiary of the bank holding company is considered an executive officer of the bank) or bank, whether or not: the officer has an official title; the title designates the officer as an assistant; or the officer is serving without salary or other compensation. The following officers are considered to be executive officers, unless they do not actually participate in major policy-making functions and are specifically excluded from such participation by resolution of the board of directors or by the by-laws of the bank or company: (1) the chairman of the board; (2) the president; (3) every vice president; (4) the cashier; (5) the secretary; and (6) the treasurer. NOTE:An extension of credit to an executive officer of an affiliate of a bank is not subject to lending restrictions found in §§ 215.4, 215.6 and 215.8 (See, below) if: the bank has excluded the executive officer from participation in major policymaking functions of the bank (and the individual does not actually participate in such functions); the affiliate does not control the bank; the affiliate’s assets are not greater that 10% of the consolidated assets of the company that controls the bank and is not controlled by any other company; and the executive officer of the affiliate is not otherwise subject to Regulation O (e.g., if the executive officer of the affiliate is also a principal shareholder, there is no exemption). To exclude an executive officer, a resolution of the board of directors or a corporate bylaw may either include the director (by name or by title) in a list of persons excluded from participation in major policymaking functions or not include the executive officer in a list of persons authorized (by name or by title) to participate in such functions. Since November 4, 1996, § 215.2(e)(2)(i) provides that only the bank’s board of directors action by resolution is required to exclude an executive officer of the bank’s affiliate from participating in the major policymaking functions of the lending bank. Extension of Credit– any transaction in which an insider receives a tangible economic benefit or the proceeds are transferred to the insider is presumed to be an extension of credit to the insider even if the transaction is made between the bank and a third party other than the insider. A review of § 215.3 contains complete lists of what is included and excluded from the definition. NOTE: The “tangible economic benefit” rule exempts tangible economic benefits to an insider arising from “arm’s-length” extensions of credit by a bank to a third party,provided the proceeds are used to finance a bona fide acquisition of property, goods or services from an insider or the related interest of an insider(e.g., this means that a loan for the purchase of a house from a builder who also happens to be a bank director is not treated as an insider loan. Likewise, a loan to a third party to purchase a car from a dealership owned by a bank director is not treated as an insider loan). In addition, non-recourse transactions (which resemble more of a purchase of assets than the lending of money) are excluded from Regulation O coverage. Debts of $5,000 or less arising by reason of an interest bearing overdraft plan is also exempted. Finally, the exemption limit for an insider’s bank credit card (or charge or time credit accounts, check credit plan or similar open-end credit plan) indebtedness from the “extension of credit” definition is $15,000. To qualify for the exemption, the credit must be on terms not more favorable than those offered to the public and may not involve prior individual clearance or approval by the bank other than for the purpose of determining the borrower’s eligibility and compliance with any applicable dollar limit. Immediate Family– includes an individual’s spouse, minor children and any of the individual’s children (including adults) residing in his or her home.
Insider– includes an executive officer, director or principal shareholder and any related interest of such a person.
Lending Limit (to a single borrower)– For national banks, the lending limit is the amount equal to the limit on loans to a single borrower (See, Section 5200,12 U.S.C. 84: 15% of bank’s unimpaired capital and surplus for loans not fully secured; an additional 10% of unimpaired capital and surplus for loans fully secured by readily marketable collateral having a market value at least equal to the amount of the loan; and any higher amounts allowed by law for loans listed as exceptions to lending limits) and for state-chartered member banks, if state law is lower than what federal law permits, such state lending limit will apply. To calculate the insider lending limit under § 215.2, Total Equity Capital, Valuation Reserves and Subordinated Notes and Debentures are added together. According to FRB guidance, the total equity capital and valuation reserve amounts are as of the call date. The subordinated notes and debentures amount is as of the loan date. These amounts are taken from the call report. [NOTE: There is also an aggregate lending limit to all insiders (See, III., G. below)].
Person– means an individual or a company.
Principal Shareholder– any person or entity (other than a bank or the bank holding company) that directly or indirectly, or acting through or in concert with others, owns, controls or has power to vote more than 10% of the voting securities of the bank. Shares owned by a member of an individual’s immediate family are deemed owned by that individual for purposes of determining his or her percentage of ownership.
NOTE:Section 22(h) of the Federal Reserve Act was amended to repeal the “small town” exception to the principal shareholder definition. The law formerly set the ownership level at 18 % for banks in towns under 30,000.
Related Interest– any company that is “controlled” by a person or company, including a political or campaign committee that an insider controls or from which the insider receives funds, services or other benefits.
Unimpaired Capital and Surplus– For a description of what constitutes “unimpaired capital and unimpaired surplus,”see, § 215.2, within the definition of “lending limit” where it defines “unimpaired capital and unimpaired surplus” to include: (1) the bank’s tier 1 and tier 2 capital included in the bank’s risk-based capital under the capital guidelines of the appropriate federal banking agency, based on the bank’s most recent consolidated report of condition; and (2) the balance of the bank’s allowance for loan and lease losses not included in the bank’s tier 2 capital for purposes of the calculation of risk-based capital by the appropriate federal banking agency, based on the bank’s most recent consolidated report of condition.
III.TREATMENT OF LOANS TO INSIDERS
A. Preferential Terms -- § 215.4(a)
Section 215.4(a) is designed to provide consistent treatment by requiring a bank to apply the same standards of creditworthiness and repayment risk to loans to insiders as it applies to loans to other borrowers. The terms of any insider loan, including interest rates and repayment schedules, must be substantially similar to terms provided to third parties. FDICIA requires a bank to follow normal credit underwriting procedures when extending credit to insiders which may not be less stringent than those applicable to comparable transactions by the bank with non-insiders.
An exception is found in § 215.4(b), effective November 4, 1996, allowing insider loans made pursuant to a benefit or compensation program that is widely available to bank employees so long as the credit does not give preference to any bank insider over other employees of the bank. A loan to an insider of a bank affiliate is also allowed if such credit terms are widely available to employees of the affiliate at which such person is an insider and does not give preference to any insider of its affiliate over other employees of the affiliate at which that person is an insider.
B. Prior Approval of Insider Loans -- § 215.4(b)
No loan may be made to an insider of the bank or the bank’s affiliates in an aggregate amount (adding all other extensions of credit to that person and his or her related interests) in excess of $25,000 or 5% of the bank’s unimpaired capital and unimpaired surplus percentage whichever is higher,unless: (1) the extension of credit has been approved in advance by a majority of the bank’s entire board of directors; and (2) the interested party has abstained from participating directly or indirectly in the voting. In any case, prior approval is required regardless of a bank’s capital and surplus when the aggregate credit extended to such person and all the related interests of that person exceeds $500,000.
C. Individual Lending Limits -- § 215.4(c)
A bank’s individual lending limit cannot be exceeded, regardless of prior board approval in that § 215.4(c) provides that any insider of the bank or bank affiliate is limited in an amount that, when added to the amount of all other credit extensions by the bank to that person and the person’s related interests, cannot exceed the bank’s lending limit (See, definition of lending limit,supra) as defined in § 215.2(i). An exception is a credit extension by a bank to a company of which the bank is a subsidiary or to any other subsidiary of that company.
D. Additional Loan Limitations for Executive Officers -- § 215.5
After a bank determines who its executive officers are, (See,definition of executive officer,supra)the bank may only extend credit to such executive officers in the following amounts and for the following purposes: (1) in any amount (subject to the bank’s loans to a single borrower limit) for the education of the executive officer’s children; (2) in any amount (subject to bank’s loans to a single borrower limit) with respect to the financingorrefinancingof the purchase, maintenance, construction or improvement of the executive officer’s residence, provided that – (a) the extension of credit is secured by a first lien on the residence and the residence is owned (or expected to be owned after the extension of credit) by the executive officer; and (b) in the case of a refinancing, only the amount used to repay the original extension of credit, together with the closing costs of the refinancing, and any additional amount thereof used for any of the purposes enumerated in this paragraph are included within this category of credit (Note: A home equity loan will not qualify for this exemption if the loan’s purpose is for anything other than the purchase, maintenance, construction or improvement of the executive officer’s residence); and (3) for “any other purpose” in an aggregate amount not to exceed the higher of $25,000 or 2.5% of the bank’s unimpaired capital and unimpaired surplus, but in no event more than $100,000(i.e.,the smallest of banks may loan at least $25,000 to an executive officer with even the largest banks being limited to $100,000 for other purpose credit, regardless of what figure 2.5% of unimpaired capital and unimpaired surplus represents). Regulation O also exempts “minimal risk” transactions from the limit of “other purpose” loans to executive officers if fully secured by the following collateral: (1) extensions of credit secured by a perfected security interest in bonds, notes, certificates of indebtedness, or Treasury bills of the United States, or in other such obligations fully guaranteed as to principal and interest by the United States; (2) extensions of credit to or secured by unconditional takeout commitments or guarantees of any department, bureau, board commission or establishment of the United States or any corporation wholly owned directly or indirectly by the United States; (3) extensions of credit secured by a perfected security interest in a segregated deposit account in the lending bank; or (4) extensions of credit arising from the discount of negotiable or nonnegotiable installment consumer paper that is acquired from an insider and carries a full or partial recourse endorsem*nt or guarantee by the insider, provided that – (a) the financial condition of each maker of such consumer paper is reasonable documented in the bank’s files or known to its officers; (b) a bank officer designated for that purpose by the bank’s board of directors certifies in writing that the bank is relying primarily upon the responsibility of each maker for payment of the obligation and not upon any endorsem*nt or guarantee by the insider; and (c) the maker of the instrument is not an insider.
Additional requirements under § 215.5(d) to be observed in extending credit to an executive officer are as follows: (1) the loan must be promptly reported to the board of directors of the bank (this requirement is only significant if the total of all loans to the executive officer and his or her related interests is less than the amounts which require prior approval by a majority of the bank’s entire board of directors); (2) the loan must comply with the terms and creditworthiness requirements of § 215.4(a); (3) the executive officer must submit a detailed current financial statement to the bankpriorto execution of the loan; (4) the loan must be subject to the condition in writing that the bank, at its option, may “call-in” the loan if at any time the executive officer becomes indebted to another bank in an aggregate amount greater than the higher of $25,000 or 2.5% of the bank’s unimpaired capital and unimpaired surplus (in no event may this percentage exceed $100,000). For bank credit card loans, these requirements are satisfied by having the board of directors grant continuing authority to borrow on an annual (up to 12 months) basis. These loan limitations also apply to partnerships in which an executive officer is a partner who maintains a majority interest in such partnership.
NOTE: Section 22(g) of the Federal Reserve Act applies to state-chartered nonmember banks. Formerly, this provision was only applicable to national banks and state member banks. Section 22(g) applies only to extensions of credit to executive officers.
E. Loan Limitations for Directors and Principal Shareholders -- §§ 215.4, 215.5, 215.8
Loans to a director are aggregated with loans made to all related interests of the director. This rule previously applied only to a member bank’s principal shareholders and executive officers. The total amount of loans to a director or principal shareholder and their related interests may not exceed the banks loans to a single borrower limit. This means that all combined extensions of credit to a principal shareholder or director (and any related interest) may not exceed 15% of the bank’s unimpaired capital and unimpaired surplus in the case of loans that are not fully secured, and an additional 10% of the bank’s unimpaired capital and unimpaired surplus in the case loans that are fully secured by readily marketable collateral.
If state law establishes a lending limit for state banks less than the amount permitted by the regulation, state law will apply to state-chartered banks. Nebraska law states that a state bank’s lending limit is the greater of (1) (25% of paid-up capital surplus, capital notes and debentures) or (2) (15% of the unimpaired capital and unimpaired surplus of the bank. There are exceptions to the lending limit listed inNeb.Rev.Stat.§ 8-141. (See, “Loans to Insiders: Nebraska State Law” article beginning on page 165 of this section).
F. Loans to Affiliates
Be aware that § 23A of the Federal Reserve Act further regulates loans to affiliates, both individually and in the aggregate. Please refer to the “NBA Compliance Handbook,Volume I, Governance section, “Relations With Affiliates: Federal Reserve Board: Section 23A” article, for further details on these restrictions and their interplay with Regulation O.
G. Aggregate Lending Limit to All Insiders -- § 215.4(2)(d)
FDICIA created a new maximum amount of credit which a bank may extend to all insiders of the bank or insiders of the bank’s affiliates. The total amount of all loans to the bank’s executive officers, directors, principal shareholders and their related interests cannot exceed a certain level. For adequately capitalized banks with deposits under $100 million, that level has been set at 200% of unimpaired capital and unimpaired surplus. For banks with deposits over $100 million, the aggregate limit on all extensions of credit to insiders and their related interests is 100% of unimpaired capital and unimpaired surplus. In order to avail itself of the 200% cap, the board of directors of an adequately capitalized bank with deposits under $100 million must annually adopt a resolution stating that the bank is establishing the aggregate lending limit for all insider and related interests borrowing at 200% of unimpaired capital and unimpaired surplus. The resolution must also certify that the higher limit is necessary to avoid restricting credit or to assist in attracting directors and that the higher limit is consistent with prudent, safe and sound banking practices.
The resolution must also set forth the facts and reasoning on which the board of directors bases the finding, including the amount of the bank’s lending to its insiders as a percentage of the bank’s unimpaired capital and unimpaired surplus as of the date of the resolution. The higher limit is only available for banks with a CAMEL 1 or 2 rating. In addition, any bank operating above the 100% limit which becomes undercapitalized may retain existing loans, but may not originate or renew existing loans that would maintain aggregate insider lending in excess of 100%.
H. Exemptions from the Aggregate Lending Limit – § 215.4(3)
The categories of exemptions to the aggregate lending limit are: (1) loans secured by obligations of the United States or other obligations fully guaranteed as to principal and interest by the United States; (2) loans secured by commitments or guarantees of a department or agency of the United States; (3) loans secured by a segregated deposit account with the lending bank; and (4) purchases of consumer installment paper from an insider with recourse, as long as the bank is relying primarily on the creditworthiness of the maker of the paper and not the endorsem*nt or guarantee of the insider.
IV.OVERDRAFT RESTRICTIONS – § 215.4(e)
No bank may pay a director’s or executive officer’s overdrafts unless: (1) the overdraft is pursuant to a written preauthorized interest-bearing plan specifying a method of repayment; or (2) the overdraft will be paid with a transfer of funds from another account at the bank and such transfer was preauthorized in writing. Inadvertent overdrafts of $1,000 or less for five days or less are not a violation as long as the director or executive officer pays the same overdraft charge as other customers. Overdraft regulations do not cover spouses unless the insider is a party or signatory on the account or the funds are not turned over to the insider.
V.EMPLOYEE USE OF A BANK-OWNED CREDIT CARD
The Federal Reserve Board (FRB) issued a legal opinion regarding the personal and business use by bank insiders of a bank-owned credit card. The opinion addressed whether and under what circ*mstances an insider’s use of a bank-owned credit card would be deemed an extension of credit by the bank to the insider for purposes of Regulation O.
Insiders of a bank often use a bank-owned credit card to purchase goods and services for the bank’s business purposes. The bank is liable to the card-issuing institution for all extensions of credit made under the card, whether for the bank’s business purposes or for an employee’s personal purposes, even if internal policies of the bank discourage or forbid this use.
In a letter dated May 22, 2006, the FRB stated that a bankdoes notmake an extension of credit to an insider for purposes of Regulation O at the time of issuance of a bank-owned credit card to the insider (regardless of whether the line of credit associated with the card is greater than $15,000). In addition, a bank doesnotextend credit to an insider for the purposes of Regulation O when the insider uses the card to purchase goods or services for the bank’s business purposes. However, when an insider uses the card to purchase goods or services for the insider’s personal purposes, the bank may be making an extension of credit to the insider. For purposes of Regulation O, an extension of credit would occur if (and the extent that) the amount of outstanding personal charges made to the card, when aggregated with all other indebtedness of the insider that qualifies for the credit card exception in Section 215.3(b)(5) of Regulation O, exceeds $15,000.
The FRB letter specifies that a “bank-owned credit card” is one issued by a third party financial institution to a bank to enable the bank, through its employees, to finance the purchase of goods and services for the bank’s business. The letter further clarifies in a footnote that the principles set forth in the letter would also apply to bank-issued credit cards, which are credit cards that a bank directly issues to their employees to enable the employees to finance the purchase of goods and services for the bank’s business.
A bank utilizing bank-owned or bank issued credit cards should consider prohibiting employees from using such cards for personal purposes. If an employee happens to use such a card for personal purposes, regardless of the reason, prompt repayment of the amounts involved should be required.
VI.INDEBTEDNESS TO CORRESPONDENT BANKS
A. Loans by Depositor Banks
Any extension of credit by a depositor bank to its correspondent bank’s insiders must be made on substantially the same terms, including interest rates and collateral, as those involved in comparable transactions with third parties.
B. Loans by Correspondent Banks
A correspondent bank may only extend credit to insiders of its depositor bank if the extension of credit is made on substantially the same terms as loans to third parties.
VII.RECORDS AND REPORTS OF BANKS
Banks may adopt their own recordkeeping method but at a minimum, regardless of the method selected, the bank must conduct an annual survey to identify its own insiders and their related interests. Banks must maintain records of all extensions of credit to insiders (and their related interest) of the bank and the bank’s affiliates including the amount and terms of each extension. Records are to be retained for a period of three years.
With respect to insiders of a bank’s affiliates, the bank may choose one of the following three methods in complying with the recordkeeping requirements:
1.Survey Method– Under this method, the bank may, through an annual survey, identify each insider of the bank’s affiliates and would reflect those insiders, along with the amount and terms of each extension of credit to any insider.
2.Borrower Inquiry Method– Under this method, when a borrower requests an extension of credit, the borrower would be required to indicate whether he or she is an insider of an affiliate of the bank. The bank would then maintain records identifying the amount and terms of each extension of credit by the bank to borrowers who have identified themselves as an insider of an affiliate of the bank.
3.Alternative Method– Under this method, a bank may employ an alternative record-keeping method for identifying insiders of an affiliate of the bank and for tracking loans to such persons. Under this alternative, the bank’s method must be shown to be at least as effective as the methods outlined above.
VIII.REPORTS REQUIRED FOR CREDIT SECURED BY CERTAIN BANK STOCK
For banks whose stock is not publicly traded, Regulation O, § 215.12 requires that the member bank’s executive officer or bank director must annually report the outstanding amount of any credit obtained from any creditor, if the indebtedness is secured by his or her bank stock shares.
IX.PUBLIC DISCLOSURE
Pursuant to written request from the public, Regulation O, § 215.11(b) states that the bank must disclose the names of executive officers and principal shareholders (including bank holding companies) and their related interests to whom the bank had outstanding loans at the end of the most recent quarter. Such disclosure need only be made if the aggregate borrowings by the insider are large enough that prior approval was necessary to make the loan. A member bank is not required to disclose the specific amounts of individual extensions of credit. The public disclosure requirement also applies for executive officer or principal shareholder loans from correspondent banks.
Section 215.11(c) provides each member bank must maintain records of all written requests from the public for the information described above and the disposition of such requests. These records may be disposed of after two years from the date of the request.
X.PENALTIES
Regulation O violations may subject an officer, director, employee, agent or other person, or even the bank itself, to civil money penalties. Section 907 of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), establishes a three-tier structure of civil penalties, under which all civil money penalties for violations of law or regulation are imposed. Under the penalty structure, violations of law or regulation can result in first-tier penalties of up to $5,000 per day. The same violations are in the second penalty tier if: (1) they result in any financial gain or other benefit to the violating party and involve recklessly engaging in an unsafe and unsound banking practice or the breach of any fiduciary duty; or (2) the violation is part of a pattern of misconduct or causes or was likely to cause more than minimal loss to the bank. Second penalty tier fines can reach $25,000 per day. Third-tier penalties, under which fines of up to $1,000,000 per day may be imposed, involves violation of laws or regulations made “knowingly” or “recklessly” where the person committing the violation causes “substantial loss” to the bank or obtains a “substantial pecuniary gain.”
Alternatively, the regulatory agency may seek the imposition of a cease and desist order in connection with Regulation O violations.
Another penalty that may be imposed involves a requirement to “call-in” an extension of credit found to be in violation of the regulation.
