T he restrictions of Sections 23A and Regulation W

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1 BNA s Banking Report Reproduced with permission from BNA s Banking Report, 100 BBR 109, 1/15/13, 01/15/2013. Copyright 2013 by The Bureau of National Affairs, Inc. ( ) REGULATION W This is the second in a series of articles concerning the three types of statutes often considered as the anti-insider abuse rules. In the last article, we discussed Regulation O, which restricts loans to bank insiders (99 BBR 652, 10/16/12). This article outlines the two statutes restricting transactions between a bank and its affiliates, Section 23A and Section 23B of the Federal Reserve Act, and their implementing regulation, Regulation W, in the context of common mistakes that are often committed by bankers. All federally regulated or insured banks are subject to these statutes, which were recently expanded by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Bank Supervision Transactions With Affiliates: Outline of Section 23a, Section 23b of Federal Reserve Act BY PETER G. WEINSTOCK AND DAVID A. SHIPLEY Peter G. Weinstock is the practice group leader of the Financial Institutions section of Hunton & Williams LLP. His practice is devoted to corporate and regulatory representation of a wide-range of financial institution franchises. David A. Shipley is an associate at the firm, where he focuses on corporate transactions and securities issuances. Common Mistake #1 Who is an Affiliate? T he restrictions of Sections 23A and Regulation W apply only to transactions with affiliates of a bank. Accordingly, the threshold question is whether the enterprise with which the bank proposes to transact business is an affiliate. Any enterprise that meets any of the following definitions is considered an affiliate: 1. Any company that controls (the term control is defined below) the bank or any company that is controlled by the bank s holding company. For instance, if COPYRIGHT 2013 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN

2 2 a bank holding company owns more than 25 percent of the stock of both a bank and a mortgage company, the mortgage company will be deemed to be an affiliate of the bank. 2. A depository institution subsidiary or financial subsidiary of a bank. 3. Any company that is controlled by shareholders who control either the bank or the bank s holding company. The regulators deem control to exist merely if the company and the bank have common shareholders who control in excess of 25 percent of the stock of such institutions, even though such shareholders are not actually acting in concert. 4. A company in which a majority of the directors or trustees constitutes a majority of the people holding such offices with the bank or the bank s holding company. 5. Any investment fund, including an investment company, for which the bank or any affiliate of the bank serves as an investment adviser. 6. Any company that is sponsored and advised on a contractual basis by a bank or one of the bank s subsidiaries or affiliates, such as a real estate investment trust or an investment advisor. 7. A company held under merchant banking or insurance company investment authority in which the bank s holding company owns or controls at least 15 percent of the equity capital, unless: (a) no director, officer or employee of the holding company serves as a director, trustee or general partner of the company, (b) a person not affiliated with the holding company owns or controls a greater percentage of the equity capital of the company than that owned or controlled by the holding company and no more than one officer or employee of the holding company serves as a director or trustee of the company, or (c) a person not affiliated with the holding company owns or controls at least 50 percent of the voting shares of the company and officers and employees of the holding company constitute less than a majority of the directors or trustees of the company. 8. Any partnership for which the bank or any affiliate of the bank serves as a general partner or for which the bank or any affiliate of the bank causes any director, officer or employee to serve as a general partner. 9. Any subsidiary of an affiliate. 10. Any enterprise that the bank s primary regulator determines to be an affiliate. The term control is defined to include the following situations: 1. If a company or a shareholder owns, has the power to vote or controls 25 percent of any class of voting securities; 2. If a company or the shareholders of a company control in any manner the election of a majority of the directors or trustees of another company; or 3. If the bank s primary regulator determines, after notice and opportunity for hearing, that a company or shareholder exercises a controlling influence over the management or policies of another company. Shares held in a fiduciary capacity will not be counted for purposes of determining control of a company. However, shares owned or controlled by a subsidiary are deemed to be controlled by the subsidiary s parent and instruments that are convertible or exercisable at the option of the holder are considered converted for purposes of determining control of a company. Example #1: A bank wholly owns an insurance company as a subsidiary. The insurance company is considered a financial subsidiary, which is a company engaging in financial activities beyond which the bank could engage in directly. Financial subsidiaries, such as the insurance company, are considered an affiliate of the bank. Example #2: A mortgage company is not owned or controlled by a bank or the bank s holding company. The mortgage company and the bank s holding company have common shareholders who control 35 percent of the stock of both the holding company and the mortgage company. The shareholders are not acting in concert. The mortgage company is considered an affiliate of the bank because of the common ownership between the holding company and the mortgage company, despite the fact that the shareholders are not acting in concert and they do not own enough of an interest to elect the members of the board. Example #3: The mortgage company in Example #2 has a subsidiary. The subsidiary of the mortgage company is also an affiliate of the bank. The following enterprises are explicitly excluded from the definition of affiliate: 1. Any subsidiary of the bank, unless the company is: (a) a depository institution, (b) a financial subsidiary, (c) directly controlled by affiliates of the bank or a shareholder(s) that controls the bank or (d) an employee stock option plan, trust or similar organization that exists for the benefit of the shareholders, partners, members or employees of the bank or any of its affiliates. 2. A company engaged solely in either: (a) holding bank premises, (b) conducting a safe deposit business or (c) holding certain government obligations; or 3. A company over which the bank assumes control because of a bona fide debt previously contracted in good faith. Example #4: A bank wholly owns a mortgage company as an operating subsidiary. The mortgage company would not be considered an affiliate because it is a subsidiary of the bank. Common Mistake #2 What is a Covered Transaction? If the enterprise with which the bank proposes to transact business is an affiliate, then management must determine whether the transaction is a covered transaction (defined below). The following are covered transactions: 1. A loan or extension of credit to an affiliate, including a purchase of assets subject to an agreement to repurchase (e.g., Fed funds sold to an affiliate, purchase of notes from an affiliate, prepayment by a bank of its estimated federal taxes to its holding company affiliate, or increase in the amount, extension of the maturity or adjustment to the interest rate of an extension of credit); 2. A purchase of or investment in securities issued by an affiliate, such as the affiliate s capital stock, bonds or debentures; 3. A purchase of assets from an affiliate, including an asset subject to recourse (e.g., a loan participation with an affiliate, merger with an affiliate if bank assumed affiliate s liabilities or pays any consideration); 4. The acceptance of securities (e.g., capital stock, bonds or debentures) issued by an affiliate as collateral COPYRIGHT 2013 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN

3 3 for a loan to any person or company other than the affiliate; 5. The issuance of a guarantee, acceptance, or letter of credit on behalf of an affiliate; or 6. A transaction, including a derivative transaction, that involves borrowing or lending of securities, to the extent that the transaction causes the bank or a subsidiary of the bank to have credit exposure to an affiliate. In general, a transaction with any person must be treated as a transaction with an affiliate to the extent proceeds of the transaction are used for the benefit of, or transferred to, an affiliate. Example #1: A bank desires to purchase a loan participation from a mortgage company that is an affiliate. The purchase of the loan participation would be considered to be a covered transaction. Example #2: A bank desires to extend the maturity date of an outstanding extension of credit made to an affiliate. The extension of the maturity date would be considered a covered transaction at the time the extension is made. Similarly, any increase in the amount or adjustment to the interest rate would also be considered a covered transaction at the time the increase or adjustment is made. Example #3: A bank desires to make an extension of credit to a shareholder of a mortgage company that is an affiliate of the bank. The extension of credit is to be collateralized by shares of the mortgage company owned by the borrower. Even though the extension of credit would be made to a non-affiliated person, the acceptance of shares issued by the mortgage company, which is an affiliate of the bank, would be considered a covered transaction. Example #4: A borrower has an outstanding loan from a mortgage company that is an affiliate of a bank. The borrower desires to refinance the outstanding loan with the bank. As part of the refinancing, the outstanding loan from the bank s affiliate will be paid off in full using the proceeds of the new loan from the bank. Because the proceeds of the bank s loan would be transferred to an affiliate, the loan by the bank to the nonaffiliated borrower would be considered a covered transaction. Common Mistake #3 What are the Limits on Covered Transactions? Covered transactions are subject to the following restrictions: 1. A bank s covered transactions are subject to two capital limitations: (a) the amount of all covered transactions carried on between a bank and any one affiliate cannot exceed 10 percent of the capital and surplus of the bank; and (b) the aggregate amount of covered transactions carried on between a bank and all of its affiliates cannot exceed 20 percent of the capital and surplus of the bank. 2. The bank, or a subsidiary of the bank, may not purchase a low-quality asset from an affiliate unless the bank committed itself, pursuant to an independent credit evaluation, to buy the asset prior to the time the asset was acquired by the affiliate. Low-quality assets include assets classified as substandard, doubtful, loss, special mention, those on non-accrual, past due more than 30 days, renegotiated assets and those acquired through foreclosure. 3. All covered transactions between a bank and its affiliates must be consistent with safe and sound banking practices. 4. No banking entity (a bank, any company that controls a bank and any affiliate or subsidiary thereof) that serves, directly or indirectly, as an investment manager, investment adviser or sponsor to a hedge fund or private equity fund, or that organizes and offers a hedge fund or private equity fund as permitted by the Volcker Rule, and no affiliate of such a banking entity, can enter into a covered transaction with the fund or with any other hedge fund or private equity fund that is controlled by such fund, subject to a limited exception for certain prime brokerage transactions. Example #1: A bank has total capital and surplus of $50 million. The bank desires to make a loan to an affiliate of the bank in the amount of $4 million. The bank has no outstanding covered transactions with the affiliate or any other affiliates. The loan, which is a covered transaction, would be permissible if it is consistent with safe and sound banking practices because the aggregate amount of all covered transactions between the bank and that affiliate would not exceed 10 percent of the capital and surplus of the bank and the aggregate amount of all covered transactions between the bank and all of its affiliates would not exceed 20 percent of the capital and surplus of the bank. The loan must also be properly collateralized, as described below. Example #2: The same bank has an outstanding loan to the same affiliate in the amount of $5 million. The bank cannot make the proposed $4 million loan to the affiliate because the aggregate amount of all covered transactions between the bank and the affiliate would exceed 10 percent of the capital and surplus of the bank. Example #3: The same bank now has no outstanding covered transactions with the affiliate but currently has outstanding two $4 million loans each to two other affiliates. Even though the proposed new $4 million loan would not cause the aggregate amount of all covered transactions between the bank and the affiliate to exceed 10 percent of the bank s capital and surplus, the proposed $4 million loan cannot be made because the aggregate amount of all covered transactions between the bank and all of its affiliates would exceed 20 percent of the bank s capital and surplus. Common Mistake #4 What Collateral Requirements Apply to a Loan to an Affiliate? In addition to the above restrictions, a proposed loan, extension of credit, guarantee, acceptance, letter of credit, credit exposure resulting from a securities borrowing or lending transaction or derivative transaction (the foregoing are collectively referred to herein as extensions of credit ) must be secured by collateral representing at least 100 percent of the amount of each such credit. The collateral required for such extensions of credit must be valued at an amount equal to the following: percent of the amount of each extension of credit, if the collateral is composed of the following: (a) obligations of the United States or its agencies, (b) obligations fully guaranteed by the United States or its agencies as to principal and interest, (c) notes, drafts, bills of exchange or bankers acceptances that are eligible for rediscount or purchase by a Federal Reserve BANKING REPORT ISSN BNA

4 4 Bank, or (d) a segregated, earmarked deposit account with the bank; percent of the amount of an extension of credit if the collateral is composed of obligations of any state or political subdivision of any state; percent of the amount of an extension of credit if the collateral is composed of other debt instruments, including receivables; or percent of the amount of an extension of credit if the collateral is composed of stock, leases or real or personal property. The collateral required must also conform to the following rules: 1. The required percentage of collateral (as set forth above) to the amount of the extension of credit must be maintained throughout the duration of the transaction. Accordingly, if any collateral is subsequently retired or amortized, it must be replaced by additional eligible collateral of equal or greater value. 2. A low-quality asset is not acceptable as collateral for an extension of credit to an affiliate. 3. The securities issued by an affiliate of a bank are not acceptable as collateral for the extension of credit. 4. Equity securities issued by the bank and debt securities issued by the bank that represent regulatory capital of the bank are not acceptable as collateral for the extension of credit. 5. Intangible assets are generally not acceptable as collateral for the extension of credit. 6. Guarantees, letters of credit and other similar instruments are not acceptable as collateral for the extension of credit. 7. The security interest in the collateral must be perfected and enforceable under applicable law and must be a first priority security interest or, if not a first priority security interest, the bank must deduct from the value of the collateral, the lesser of the amount of any security interest in the collateral or the amount of any credit secured by the collateral that is senior to that of the bank. Example #1: A bank makes a $1,000 loan to an affiliate. The affiliate posts as collateral for the loan $500 in U.S. Treasury securities, $480 in corporate debt securities and $130 in real estate. The loan has been properly collateralized because the U.S. Treasury securities are valued at 100 percent, which accounts for $500 of the loan, the corporate debt securities are valued at 120 percent, which accounts for $400 of the loan, and the real estate is valued at 130 percent, which accounts for $100 of the loan. The total amount of the collateral is $1,110 even though the loan amount is only $1,000. Common Mistake #5 Transactions Exempt from Section 23A? The following transactions are exempt from the provisions of Section 23A, except for the requirement that such transactions must be on terms and conditions that are consistent with safe and sound banking practices: 1. Any transaction with another bank which (a) has 80 percent of its voting shares controlled by the bank, (b) controls 80 percent of the voting shares of the bank, or (c) has 80 percent of its voting shares controlled by the same enterprise that controls 80 percent of the voting shares of the bank. The purpose of this provision is to enable 80 percent or more owned sister banks within a bank holding company system to act as the functional equivalent of branches, thereby improving their efficiency through intercorporate transfers. Regulatory concern regarding affiliated transactions is also reduced because both entities are subject to similar, if not the same, regulator and examination oversight. A lowquality asset, however, may not be transferred between sister banks except pursuant to a prior commitment as discussed above. 2. Deposits made in an affiliate bank in the ordinary course of correspondent business. 3. Any transaction in which an affiliate is given immediate credit for uncollected items received in the ordinary course of business. 4. An extension of credit secured by certain governmental obligations or a segregated, earmarked deposit with the bank. 5. The purchase of securities of a company engaging solely in the business of either (a) holding the bank s premises, (b) conducting a safe deposit business or (c) furnishing services to the bank. 6. The purchase of assets that have a readily identifiable and publicly available market quotation and that are either (a) purchased at that market quotation or (b) purchased on a non-recourse basis (but such assets may not be low-quality assets). 7. The purchase from an affiliate of an extension of credit originated by the bank and sold to the affiliate subject to a repurchase agreement or on a recourse basis. 8. A purchase of assets from an affiliate if (a) part of an internal corporate reorganization of a holding company that involves the transfer of all or substantially all of the shares or assets of an affiliate or of a division or department of an affiliate, (b) the bank provides written notice of the transaction before consummation to the appropriate federal banking agency and the Federal Reserve, (c) the top-tier holding company commits to make quarterly cash contributions to the bank for a 2 year period to cover assets that have become lowquality assets or to repurchase such low-quality assets, (d) the transaction is reviewed and approved by a majority of the bank s directors, (e) the value of the transaction, together with the value of any other transaction engaged in under this exemption during the preceding 12 months, is less than 10 percent of the bank s capital and surplus and (f) the holding company all subsidiary banks are well capitalized and well managed and would remain well capitalized following the transaction. 9. A purchase of an asset from affiliate by a newly formed bank, if approved in connection with the formation of the bank. 10. A merger or consolidation with, or an acquisition of assets or assumption of liabilities from, an affiliated depository institution if approved pursuant to the Bank Merger Act. 11. An intraday extension of credit to an affiliate if the bank (a) has established policies and procedures reasonably designed to manage the credit exposure, (b) has no reason to believe the affiliate will have difficulty repaying the extension of credit and (c) ceases to treat any such extension of credit as an intraday extension of credit at the end of the business day. 12. The purchase of securities from an affiliate that is registered with the Securities and Exchange Commission as a broker or dealer or is approved by the Federal Reserve if the bank or affiliate is acting exclusively as a riskless principal, meaning the principal purchases or sells the security in the secondary market for its own COPYRIGHT 2013 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN

5 5 account to offset the transaction, and the security is not issued, underwritten or sold as principal by an affiliate of the bank. 13. The sale of assets to an affiliate. Example #1: A bank desires to sell a parcel of real estate to an affiliate. The sale of assets to the affiliate is not a covered transaction under Section 23A and Regulation W but is still subject to the provisions of Section 23B discussed below. If the bank were to purchase the assets from the affiliate, it would be a covered transaction. Example #2: A bank desires to make a loan to another bank. The same holding company owns 90 percent of the voting shares of both banks. The loan between the banks would be exempt from the provisions of Section 23A and Regulation W but must be consistent with safe and sound banking practices. Other Provisions of 23A, 23B and Reg W Valuation and Timing under Regulation W Regulation W, in addition to further defining the requirements of Sections 23A and 23B, sets out the requirements for determining how to value covered transactions and determining when a covered transaction occurs. With respect to a loan, extension of credit, guarantee, acceptance, letter of credit (collectively a credit transaction ), the credit transaction must be initially valued at the greater of the principal amount, the amount owed by the affiliate to the bank or the sum of the amount provided to, or on behalf of, the affiliate and any additional amount the bank could be required to provide to, or on behalf of, the affiliate. If the credit transaction is acquired from a nonaffiliate, the credit transaction must be initially valued at the sum of the total consideration given for the credit transaction and any additional amount the bank could be required to provide to, or on behalf of, the affiliate. Generally, a credit transaction with an affiliate occurs at the time the bank becomes legally obligated to make the credit transaction or at the time the bank acquires the credit transaction. With respect to a purchase of assets from an affiliate, the purchase must be valued at the total consideration given for the asset, reduced to reflect amortization or depreciation to the extent consistent with generally accepted accounting principles ( GAAP ). The purchase remains a covered transaction as long as the bank holds the asset. With respect to a purchase or investment in securities issued by an affiliate, the purchase or investment must be valued at the greater of the total consideration given in exchange for the security, reduced to reflect amortization of the security to the extent consistent with GAAP, or the carrying value of the security. The purchase or investment remains a covered transaction so long as the bank holds the security. With respect to the acceptance of securities issued by an affiliate as the exclusive collateral for a loan, the transaction must be valued at the lesser of the total value of the loan or the fair market value of the securities that are pledged as collateral. If securities issued by an affiliate are only part of the collateral for a loan, the transaction must be valued at the lesser of the total value of the extension of credit less the fair market value of non-affiliate collateral or the fair market value of the securities issued by an affiliate that are pledged as collateral. Section 23B In addition to the above-described restrictions under Section 23A and Regulation W, Section 23B of the Federal Reserve Act was adopted in anticipation of legislation permitting commercial banks to become affiliated with securities firms. Section 23B was intended to prevent conflicts of interests between banks and affiliated securities firms, but it also reaches transactions in which securities are not involved. Under Section 23B, a bank or its subsidiary may engage in the transactions listed below (listed transactions) with an affiliate (for purposes of Section 23B, banks are not affiliates of other banks even though they would otherwise meet the definition of an affiliate) only on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to such bank or its subsidiary, as those prevailing at the time for comparable transactions with or involving other non-affiliated enterprises. In the absence of comparable transactions, the bank or its subsidiary may only engage in such listed transactions on terms and under circumstances, including credit standards, that in good faith would be offered to nonaffiliated companies. Listed Transactions: The following are listed transactions: 1. Any covered transaction with an affiliate; 2. The sale of securities or other assets to an affiliate, including assets subject to an agreement to repurchase; 3. The payment of money or the furnishing of services to an affiliate under contract, lease or otherwise; 4. Any transaction in which an affiliate acts as an agent or broker or receives a fee for its services to the bank or to any other person; and 5. Any transaction or series or transactions with a third party: (a) if an affiliate has a financial interest in the third party or (b) if an affiliate is a participant in such transaction or series of transactions. In general, a transaction with any person must be treated as a listed transaction with an affiliate if any of the proceeds of the transaction are used for the benefit of, or transferred to, an affiliate. Prohibited Acts Section 23B also prohibits a bank or its subsidiary from engaging in the following: 1. When acting as fiduciary (such as when the bank acts as trustee) purchasing any securities or other assets from an affiliate, unless such purchase is permitted under either: (a) the instrument creating the fiduciary relationship, (b) court order or (c) by the law of the jurisdiction governing the fiduciary relationship; 2. Whether or not acting as fiduciary, knowingly purchasing or otherwise acquiring, during the existence of any underwriting or selling syndicate, any security if a principal underwriter of that security is an affiliate, unless the purchase or acquisition of such security has been approved, before such securities are initially offered for sale to the public, by a majority of the directors of the bank based on a determination that the purchase is a sound investment for the bank irrespective of the fact that an affiliate of the bank is a principal underwriter of the securities; and BANKING REPORT ISSN BNA

6 6 3. Publishing any advertisement or entering into any agreement stating or suggesting that the bank will in any way be responsible for the obligations of its affiliates. Civil Money Penalties Violators of the statutes restricting transactions with affiliates or Regulation W are subject to civil money penalties of up to $1,000,000 per day for each day the violation continues. In summary, whenever there is a possible transaction with an affiliate, the bank needs to ask: s s Is the entity an affiliate? Is the activity a covered or a listed transaction? s Are the covered transactions, as well as certain other transactions with affiliates, on substantially similar terms as available to third parties? COPYRIGHT 2013 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN