Since 1978, a bank's loans to its directors, executive officers, and principal shareholders -- the insiders -- as well as loans to their related interests have been subject to special scrutiny pursuant to Regulation O.
Proposed regulations by the Federal Deposit Insurance Corp. would subject virtually all transactions between a bank and its insiders to an "arm's length" standard.
As bankers' experience in complying with Regulation O and Section 23A of the Federal Reserve Act will attest, a determination of whether terms are the product of arm's-length negotiations is difficult to make, is based on subjective factors, and will be subject to regulatory second-guessing.
At a minimum, the proposed regulations will significantly increase the level of documentation required in connection with transactions between a bank and its insiders.
OCC and Fed May Join In
The FDIC's proposed regulations would apply to all transactions by state nonmember banks, their insiders, and their related interests. According to the proposals, the Comptroller of the Currency and the Federal Reserve Board are also considering regulations governing insider transactions.
In the press release announcing the proposed regulations, FDIC Chairman L. William Seidman stated:
"Inadequate recordkeeping nearly always contributes to insider abuse and hampers our investigations of these abuses.
"In addition, we have found that institutions victimized by fraud and abuse typically lack written policies and procedures to detect insider involvement early enough to prevent a problem. We believe the proposals being issued today by the FDIC would go a long way toward addressing these and other causes of insider fraud and abuse."
Adoption Is Likely
It seems likely that the FDIC's proposals will be adopted in some form. These proposed regulations would require banks to:
* Conduct almost all transactions with insiders and their related interests on an arm's-length basis.
* Adopt written guidelines covering insider business transactions.
* Maintain certain records, including the names of the parties, their relationship to the bank, and a description of the transaction.
* Review insider business transactions for compliance with the bank's internal guidelines.
Banks would be prohibited from making equity investments in real estate projects in which an insider or its related interest already has an equity investment.
The proposed regulations provide "business dealings" between an insider, or its related interests, and the bank to be on arm's-length terms. The term "business dealings" includes:
* Sale, purchase, or other conveyance of assets, goods, or services to or from the bank.
* Use of the bank's facilities, property, or personnel.
* Lease or property, equipment, or other assets to or from the bank.
* Payment by the bank of commission or fees, such as legal or accounting fees.
* Service agreements, such as provision of data-processing services by a company an insider owns.
* Payment of interest on deposits at a rate in excess of that paid to other depositors on similar deposits.
Third Parties in Picture
Significantly, the proposed regulations provide that any transaction with a third party that provides a direct or indirect economic benefit to an insider or its related interests is a transaction with an insider. Accordingly, "business dealings" encompass almost all transactions between a bank and its insiders or their related interests.
If a transaction is a business dealing with an insider, it must be:
* Intended for the benefit of the bank and not be entered into by the bank merely as an accommodation of the insider.
* On terms and other circumstances that are substantially the same as prevailing for transactions with third parties.
* Approved in advance by a majority of the board of directors, if the value of the transaction -- aggregated with all other transactions involving that insider and its related interests during the bank's current fiscal year -- exceeds the lesser of the $500,000 or 2.5% of the bank's Tier 1 capital. Transactions above this threshold are considered "major transactions."
The proposed regulations require a bank to adopt written guidelines governing the circumstances and conditions under which it will engage in transactions with insiders and their related interests. These guidelines must be reviewed and approved at least annually by the bank's board of directors, and copies of the guidelines must be sent to all of the bank's insiders. Copies do not need to be sent to related interests of insiders.
The guidelines should address:
* The extent to which an insider may participate in the bank's consideration of the transaction.
* The circumstances under which the bank will make its facilities available to an insider.
* A description of the types of transactions deemed so 'insignificant" that they are not subject to the arm's-length restriction or prior approval of the regulation. "Insignificant" transactions is intended to cover small "perks," such as use of copying machines.
Major transactions with an insider or its related interests must be approved in advance by the board of directors. The minutes of the meeting at which such a transaction is approved must contain:
* Names of the parties to the transaction.
* Relationship of the parties to the bank.
* Brief description of the transaction and its terms.
* A notation that any dissenting votes cast along with the basis of the dissent.
* A notation that all interested parties abstained from voting on or participation in, directly or indirectly, the deliberations regarding the transaction.
Any insider involved in the transaction must disclose to the board all relevant, material, nonconfidential information regarding the transaction, so that the board can evaluate the transaction fully and adequately.
As with extensions of credit under Regulation O, it is possible to elect to satisfy the prior approval requirement of the regulation once a year. Accordingly, the board of directors may approve transactions in advance for a reasonable maximum dollar amount.
For example, a bank that purchases office supplies from a firm controlled by an insider may approve several purchases at once, up to a maximum dollar amount. Please note that such approval is good only for the bank's fiscal year -- or until the value of the transactions exceed the amount approved.
The proposed regulations require banks to keep adequate, centralized records of all insider transactions -- regardless of amount.
The records must contain the same information that is required in board minutes for major transactions.
Minutes of the meetings at which those transactions were approved may be used to satisfy this portion of the recordkeeping requirement.
Real Estate Investments
In some states, banks are permitted to invest in real estate. The proposed regulations prohibit banks in these states from making equity investments in real estate in which an insider or its related interests possess an equity investment.
The prohibition, however, does not prevent a bank from investing in real property that is used or intended to be used for the conduct of business for future expansion. This type of transaction would still be subject to other provisions of the regulation, such as the arm's-length standard and prior-approval requirement.
Banks would also be permitted to acquire property in satisfaction of a debt previously contracted in good faith, and to purchase real estate from an insider or its related interests.
The proposed regulations set forth certain considerations that will be evaluated to determine whether a loan by a bank is in reality an equity investment.
If a loan were deemed to be an investment in real estate, it would be prohibited. This aspect of the proposed regulation would apply even in states that permit banks to make only limited investments -- or none at all -- in real estate.
The proposal would create four classes of business dealings between a bank and its insiders and their related interests:
* Transactions that are insignificant in nature and, accordingly, are not subject to the restrictions of the proposed regulation.
* Transactions subject to an arm's-length standard, but not significant enough in amount to require prior board approval.
* Transactions that require prior approval by the bank's board of directors.
* Equity investments in real estate that are prohibited because an insider or its related interests possesses or will possess an equity investment in such property.
The goal underlying the proposed regulations is worthwhile. Transactions between a bank and its insiders should be on arm's-length terms and conditions, and major transactions should receive prior board approval.
As a practical matter, however, the time and expense required to document that terms are arm's-length can be considerable. Moreover, the determination of whether terms are arm's-length is subjective.
Transactions subject to the arm's-length requirement under either Regulation O or Section 23B have been approached with second-guessing using 20/20 hindsight. The uncertainty associated with this type of scrutiny has caused bankers to avoid otherwise appropriate transactions.
The proposed regulations, if adopted, will expand such scrutiny to encompass virtually all types of transactions between a bank and its insiders. Consequently, one likely effect of the proposed regulations, if adopted, will be a reduction in the level of all transactions between banks and their insiders.