Regulation O and Tangible Economic Benefits

Issue/Inquiry

The son of a director of the Bank has requested a loan from the Bank which will be secured by his residence, and which will be used to pay off the loan from the director. The residence had been purchased by the son with the loan from the director. What are the Regulation O implications?

Response Summary

The loan from the Bank to the son of the director is subject to an exception from the tangible economic benefit rule, provided that the loan from the director to the son bore a reasonable relationship to the value of the property purchased.

Response Detail

An “insider” for Regulation O purposes is an executive officer, director, or principal shareholder of a financial institution or any related interest of such a person. A “related interest” is a company or political campaign controlled by that person. 12 CFR §215.2(h), (n).

Insider loans are subject to certain restrictions under Regulation O, including:

• Terms and underwriting conditions must be the same as for loans which are not made to insiders
• Prior approval of a majority of the board of directors (the insider not being a participant), if the aggregate obligations of the insider to the bank, including the loan in question, exceed the higher of 15 percent of unimpaired capital and surplus of the bank or $25,000
• Limitations on the total amount of credit extended to the insider, as per 12 U.S.C. 84. (i.e., 15 percent of a bank's unimpaired capital and surplus. A bank may lend an additional 10 percent of its unimpaired capital and surplus if the loan is secured by “readily marketable collateral” [e.g., listed securities and gold bullion]. Loans secured by deposits with the bank or by obligations of the United States may be made in an unlimited amount). 12 CFR §215.4(a)(1), (b), (d).

The director would be an insider of the Bank, but the son of the director would not be considered a related interest of the director, as he is not a company or political campaign controlled by the director.

Regulation O, however, also has a “tangible economic benefit” rule which provides that an extension of credit to someone other than the insider can still be deemed to be to the insider, as follows:

Tangible economic benefit rule – (1) In general. An extension of credit is considered made to an insider to the extent that the proceeds are transferred to the insider or are used for the tangible economic benefit of the insider. 12 CFR §215.3(f)

In this case, the director would ordinarily be considered the recipient of the loan under the tangible economic benefit rule, if the son transferred the proceeds of the loan to him. There is an exception to the rule, however, by which an extension of credit is not considered made to an insider if the proceeds of the extension of credit are used in a bona fide transaction to acquire property, goods, or services. 12 CFR 215.3(f)(2).

The Federal Reserve Board found this exception to be applicable when the proceeds of a bank’s loan to the son of an insider were used to pay off a loan from the insider which had been used to for the construction of his residence:

It is our opinion that the exception to the tangible economic benefit rule should apply in this case regardless of the manner in which the son retired the original loan from the director. The exception requires that an extension of credit be used in a bona fide transaction to acquire property, goods, or services in order to prevent transactions from qualifying for the exception when the borrower from the bank serves merely as a nominee for the insider. This would occur if the borrower from the bank transferred the proceeds of the bank loan to the insider without adequate consideration. In this case, in the absence of any evidence that the amount of the original loan from the director (which the loan from the bank was used to repay) was inflated beyond the actual and reasonable construction costs for the son's house, the Board's concern that the exception to the tangible economic benefit rule not be used to shield nominee loans would be satisfied.

The Federal Reserve Board further noted that the transaction would be identical, in terms of the economic relationships established among the parties and the credit risk assumed, if the director had sold the son's note to the bank without recourse. The sale or discount of a promissory note to a bank, without recourse to the transferor of the note, is treated under Section 215.3(b)(7) of Regulation O as the purchase of an asset by the bank and not as an extension of credit to the transferor.  Federal Reserve Board, Legal Interpretations, December 10, 1998.

When applying this ruling in this instance, the Bank should determine whether the loan from the director to his son bore a reasonable relationship to the value of the property acquired by the son. If it does, then the loan to the son by the Bank, the proceeds of which would be used to pay off the loan to the director, would be analogous to a loan for the purchase of the residence. The Bank should document this fact in its minutes, along with the terms and conditions of the loan.

Given that the determination of whether this exception to the tangible economic benefit rule is applicable rests on a question of fact, we believe that the better practice would be to treat the presentation of the loan as one which is potentially to the benefit of the director. As such, the director should excuse himself from the meeting and take no part in the discussion or decision by the Board. The minutes of the Board meeting should also reflect this.

This entry was posted on Monday, April 17th, 2017 at 1:34 pm.