Regulation O and the Indebtedness of Executive Officers to Other Banks

Issue/Inquiry

With regards to Regulation O requirements concerning loans to executive officers, what are some best practices for aggregating loans with other banks and what is the best way of obtaining written notice of such loans?

Response Summary

Regulation O requires a “due on demand” clause in the loans a bank makes to its executive officers. The regulation requires a formal internal reporting regime regarding the indebtedness of such officers to other banks; however, federal guidance indicates that a bank should have a system that ensures the effectiveness of the clause in a reasonably prudent way. This could include requiring executive officers to provide periodic reports of their indebtedness to other banks.

Response Detail

Regulation O requires a “due and payable upon demand” clause in any loan made to an executive officer, as follows:

Made subject to the condition in writing that the extension of credit will, at the option of the member bank, become due and payable at any time that the officer is indebted to any other bank or banks in an aggregate amount greater than the amount specified in paragraph (c) of this section. 12 CFR §215.5(d)(4).

The referenced paragraph sets a limit of 2.5 percent of a bank’s unimpaired capital and unimpaired surplus or $25,000, but in no event more than $100,000, unless it is for one of the following purposes:

• In any amount to finance the education of the executive officer’s children;
• In any amount to finance or refinance the purchase, construction, maintenance, or improvement of a residence of the executive officer, provided that the extension of credit is secured by a first lien on the residence owned by the executive officer and, in the case of a refinancing, only the amount thereof is 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 enumerated purposes;
• In any amount, if the extension of credit is secured by certain collateral (e.g., U.S. bonds and treasury notes, segregated deposit accounts) 12 CFR §215.5(c).

This means that if the aggregate sum of loans made to an executive officer by other banks exceeds the amount that the Bank would be permitted to make to the executive officer, then the Bank has the option of demanding payment in full of the loans it made to the executive officer, as per the demand clause in the notes evidencing such loans.

Note, however, that while Regulation O references “member banks” (banks which are members of the Federal Reserve), FDIC regulations basically defer to Regulation O regarding limits on extensions of credit to executive officers, directors, and principal shareholders of FDIC-insured nonmember banks. 12 CFR §337.3.

At one time, Regulation O made banks subject to formal reporting requirements regarding the indebtedness of its executive officers to other banks. However, these requirements were removed by section 601 of the Financial Services Regulatory Relief Act of 2006 (the “Relief Act”). FFIEC, FIL-108-2006 (December 18, 2006).

In revising Regulation O to implement this provision of the Relief Act, the Federal Reserve Board noted that the “due on demand clause” of the regulation derives from section 22(g) of the Federal Reserve Act, which remains in effect. Therefore, a bank would be required to include the “due on demand” clause in each of its extensions of credit to executive officers, but Regulation O would no longer require a specific reporting regime regarding the indebtedness of executive officers to other banks.

As there is no longer a formal reporting requirement, the Federal Reserve Board recommends that a bank do the following instead:

Going forward, a bank may choose to ensure the effectiveness of the due on demand clause requirement in any reasonably prudent way. For example, a bank may comply with the requirement by mandating a periodic report from its executive officers. Alternatively, a bank may decide to obtain information about an executive officer borrower’s indebtedness to other banks only at the time the bank would be interested in exercising the due on demand clause (for example, when the creditworthiness of the officer has dropped materially). Either of these methods could, based on all the facts and circumstances, be a reasonable way to ensure the utility of the due on demand clause requirement. 72 Federal Register 30470, 30472 (December 11, 2006).

Since the Bank is required to include a “due on demand” clause in each of the loans to its executive officers, it must also have a reasonably prudent method of obtaining information on the indebtedness of those officers to other banks. The Federal Reserve Board provided the example of a “periodic report from its executive officers” as one approach. Conceivably, this could be a report provided by the executive officers on a monthly or quarterly basis. In terms of ease and prudence, however, we suggest the following alternatives:

• A report can be obtained from existing executive officers as to their current indebtedness to other banks;
• A report can be obtained from an executive officer at the time of hire as to his or her current indebtedness to other banks;
• Executive officers, thereafter, would be required to report new indebtedness to other banks within a week (or some other reasonable period) after incurring the indebtedness.

The report should provide the amount of the loan, the bank from which it was obtained, the date of the loan, and its purpose. The Bank would aggregate the loans by purpose in order to determine when the balance of particular loans might exceed the regulatory limit.

We believe that this reporting regime will mitigate against gaps in the required information or surprises, and keep the Bank informed as to the current status of the indebtedness of its executive officers to other banks.

This entry was posted on Monday, March 18th, 2019 at 6:00 am.