A bank appealed a violation
of insider lending limitations cited in the most recent examination
report.
The violation involved overdrafts on the personal checking
account of the bank's chairman of the board (COB). The COB
overdrew his account at the bank 21 times over a 161-day period
during 1995. The overdrafts were less than
$1,000 in amount, less than five days in duration, and subject to
appropriate charges. However, the supervisory office
concluded that the frequency and dollar amounts involved indicate
that the overdrafts should not be considered inadvertent. The
examination report also cited several other insider violations that
the bank did not appeal. OCC notified the bank that it is
strongly considering civil money penalties (CMPs) against the COB
and other individuals who approved loans causing violations or
failed to prohibit the COB's overdrafts. The
supervisory office notes that the bank has experienced chronic
insider loan problems, often involving the COB, since he acquired
the bank in 1989. These problems include previous
illegal overdrafts in 1992 and 1993. In 1993, the OCC issued a letter
of reprimand to the COB and supervisory letters to other insiders
addressing the bank's insider lending practices. The
bank's board of directors adopted a policy that disallowed the
payment of any overdrafts on the accounts of officers and directors.
Discussion
The regulation dealing with
overdrafts of an executive officer is 12 CFR 215.4(e). It
prohibits member banks from paying an overdraft of an executive
officer or director except in accordance with a written,
preauthorized, interest-bearing extension-of-credit plan. There
is also an exception for a written, preauthorized transfer of funds
from another account of the account holder at the bank. This
prohibition does not apply to inadvertent overdrafts on an account
in an aggregate amount of $1,000 or less, provided that the account
is not overdrawn for more than five business days, and the member
bank charges the executive officer or director the same fee charged
any other customer of the bank in similar circumstances.
Counsel for the bank argues
that the above-stated provision should be interpreted to mean that
an overdraft is inadvertent if it is less than $1,000, remains for
no more than five days, and is charged the same fee charged any
other customer. In other words, the provision
should be read as though the word "inadvertent" was unnecessary or
omitted.
The appeal maintains that the OCC's determination is based
upon subjective criteria not included in the regulation. As
such, it is inherently unfair and arbitrary because the OCC's
apparent maximum number of permissible overdrafts has not been
disclosed to anyone in advance. Thus, it is not possible to
anticipate or predict OCC's conclusions.
OCC and Federal Reserve
Board precedents provide no support for counsel's position. In
1989, the OCC ruled that "[a]n overdraft that is not made in
accordance with a written, preauthorized payment plan is permissible
under 12 CFR 215.4(d) only if it is inadvertent, in an amount of
less than $1,000, does not exceed five business days, and the bank
charges the executive officer or directors the same fee charged to
other customers" (emphasis added). Decision of the Comptroller of
the Currency No. AA-EC-87-123, January 12, 1989. In this
decision, the Comptroller saw "inadvertence" as a requirement of the
provision.
The COB states that an
employee maintains his checking account for him. He was
unaware of the 1995 overdrafts until after the fact. When
notified of the overdraft activity, the COB was certain the bank was
in error.
Upon analysis, he was surprised to find that the bank
statements were accurate. Therefore, he believes the
overdrafts were inadvertent. However, the OCC had notified the
bank in a 1993 letter from the supervisory office that, in part,
because a pattern was present, the overdrafts could not be
considered inadvertent - regardless of the amount or duration. In
addition, the letter of reprimand to the COB stated that he had
caused overdrafts to occur in his accounts and his related interests
accounts.
The letter reminded him of his fiduciary obligations to the
bank.
The reprimand concluded by stating that OCC would consider
its issuance to be a formal prior supervisory warning should he be
involved in future violations, unsafe and unsound practices, or
breaches of his fiduciary duty. Further, several members of
management and the board received training and information about
insider loan limitations in the month just prior to the approval of
the 1995 illegal insider transactions.
Conclusion
The Ombudsman decided that
the overdrafts are not inadvertent. He decided that the overdrafts
are not inadvertent. He believes that the provisions
in the regulation (i.e., less than $1,000, no more than five days,
and charged the same fee as any other customer) are separate and
distinct conditions from the term "inadvertent." The
inclusion of the word in the regulation provides a fourth condition
necessary to exempt certain overdrafts from the prohibition cited in
the regulation. He based this appeal decision on
the language of the regulation, OCC legal precedent, and the extent
of the COB's overdraft activity.
The COB has repeatedly been in the
position of overdrafting his checking account an inordinate number
of times.
His experience with overdrafts in 1992 and 1993, the bank's
policy prohibiting overdrafts on accounts of officers and directors
and the letter of reprimand from the OCC, raised the issue to a
level of consciousness that eliminates the possibility of
inadvertence in 1995. Bank insiders have positions of
responsibility and leadership in the community. As
such, they must avoid even the appearance of transactions that are,
or could become, abusive. Although the impact of such
transactions may seem small, they are symptomatic of a lax approach
to the responsibility insiders owe the bank and its depositors. The
ombudsman appreciates the COB's surprise upon learning of the
overdrafts. However, delegating the
management of his personal account does not excuse the COB of his
responsibility to ensure that it is handled in a legal and
responsible manner. The cited violation in the
examination report will remain.
APPEAL OF VIOLATION (First Quarter
1996)
A bank appealed to the
ombudsman a violation of 12 CFR 9.12 (a) cited in its 1993 report of
examination (ROE.) In response to the Roe, the bank first sought
relief from the supervisory office by making a request for an
interpretive ruling. The supervisory office, through district
counsel, upheld the examination results in that first-tier appeal.
In 1995, the bank made a formal second-tier appeal to the ombudsman
that requested a review of the conflict of interest issues in its
method of utilizing the services of its third-party provider of
discount brokerage services for the settlement of the fiduciary
security transactions.
Background
The bank wanted to continue
to use its unaffiliated third-party provider to transact discount
brokerage services for the bank's trust department. The contractual
agreement allowed trades only for nondiscretionary trust accounts
and bank accounts. No trading in discretionary trust accounts was
permitted under the agreement. Under the terms of this agreement,
the bank received 50 percent of the brokerage commissions.
The bank also shared in
brokerage commissions that were charged discretionary trust accounts
by the unaffiliated third-party broker for services the broker
rendered to those trust accounts. These trades are not governed by
the bank's contract with the third-party broker. However under the
bank's commission arrangement with the discount brokerage, the bank
received a flat fee for each discretionary trust transaction. The
bank provided information that indicated that it did not "profit"
from this type of trust transaction but that the fee represented
only a partial recovery of the bank's cost to process a trade. The
bank also provided a comparison of other brokerage commission
alternatives that indicated that its provider was cost effective.
Lastly, the bank's contract with its brokerage provider did not
contain any activity-based escalator clauses.
Discussion
Regulation 12 CFR 9.12 (a)
states:
Unless lawfully authorized by the instrument
creating the relationship, or by court order or by local law, funds
held by a national bank as fiduciary shall not be invested in stock
or obligations of, or property acquired from, the bank or its
directors, officers, or employees or individuals with whom there
exists such a connection, or organization in which there exists such
an interest, as might affect the exercise of the best judgment of
the bank in acquiring the property, or in stock or obligation of, or
property acquired from affiliates of the bank or their directors,
officers or employees.
The OCC enacted 12 CFR 9.12
(a) to codify for nationally chartered banks the pervasive state
common law principle that trustees owe their trust beneficiaries a
duty of loyalty. The duty of loyalty is a basic, underlying tenet of
the common law of trust. A trustee's duty of loyalty requires the
trustee to avoid transactions that, as the regulation states,
"might" cause the trustee to disregard or ignore the trust
beneficiaries' interests.
OCC Fiduciary Precedent
9.3905 identifies the existence of a conflict of interest when a
bank uses a brokerage service to execute trades for the bank's trust
accounts when the bank also receives "a share of the commissions or
other consideration"; a flat transaction fee should certainly
qualify as "other consideration." Fiduciary Precedent 9.3905 further
states that:
A
brokerage service may be used for fiduciary accounts if the bank
receives no compensation from the broker and fiduciary accounts
receive best execution. If the bank receives compensation in any
form, then the trust customers must provide specific written
authorization to use the brokerage firm after being provided with
full disclosure of the arrangement.
Thus, the bank has violated
12 CFR 9.12 (a) through its use of the third-party broker to effect
trades for the bank's discretionary fiduciary accounts, but not
because the third-party broker is somehow "affiliated" with the
bank. It is the bank's receipt of a flat fee from the third-party
broker for each fiduciary account transaction that causes the
transactions to be in violation of section 9.12 (a). Key to this
discussion is the fact that the bank already charges a trustee fee
to cover just such expenses. The bank's brokerage agreement with the
third-party broker alone would not make the broker a bank "related,"
"affiliated or "in-house" brokerage service as the ROE implied.
The OCC has previously
reviewed conflicts of interest where an unaffiliated broker in a
contractual relationship with a bank executes trades for trust
accounts, even when no fee is imposed. The contractual relationships
are similar in this situation; however, the appealing bank received
a flat fee. Notwithstanding the absence of any fee to the bank for
trust account trades, the OCC previously concluded that there is a
potential for indirect benefit to the bank under such an
arrangement. The Bank's contractual arrangement with the third-party
broker might affect the trust department's ability to make brokerage
choices that are based exclusively on the best interest of its trust
customers, even if the bank received no portion of the commission
from the trust account trades. The size of the bank's contractual
share of the broker's commissions form the non-trust account trades
might have been, or may continue to be influenced by the broker's
ability to generate revenues from the trust department. Also, the
existence of the contractual relationship between the bank and the
broker might be dependent on the broker receiving revenues from
trust accounts. The bank may be placed in a position where its
judgment concerning which broker to use for trust account trades may
be unduly influenced by the desire to maintain the contractual
relationship with the third-party broker. The absence of
volume-related commission scheme does not preclude the potential for
indirect benefit to the bank.
Conclusion
The ombudsman decided that
the bank's retention of the brokerage fee from the third-party
provider does constitute a violation of 12 CFR 9.12 (a). To avoid a
violation, the bank must meet one of the exceptions explicitly
stated in section 9.12 (a) or obtain the informed consent of its
trust customers.
The ombudsman also provided
an alternative solution for the bank to avoid a violation of section
9.12. The bank could give each fiduciary account the flat fees it
collected from the trades made for that account. In this manner, the
bank would not be receiving any compensation form the third-party
broker for placing the bank's discretionary accounts' trades. This
potential solution will only be appropriate as long as the bank
makes certain representations and adheres to them. These
representations include:
- The bank is crediting whatever benefits it is
receiving form the third-party broker to its trust accounts. In the
appeal letter, the bank represented that the only benefit the bank
receives form the third-party broker for the discretionary trust
trades was a flat fee per trade. Therefore, if the bank gives these
fees to the trust account whose trades generated the fees for the
bank and the bank seeks best execution for its trust account trades,
then the potential conflict of interest is so minimal that the OCC
would permit this activity. However, if the bank begins receiving
additional benefits, either directly or indirectly from these
trades, and then the OCC would have to review the situation in light
of the additional benefits and the potential conflicts they
represent.
- The bank must continue to seek best execution
on all its discretionary trust account trades. While the bank
represented that the third party broker currently offers the least
expensive brokerage service, if this situation changes and a
different brokerage service offers better rates, then the bank would
have a duty to seek best execution with the other brokerage
service-assuming that there are no other considerations that would
keep the bank from using that brokerage service.
APPEAL OF VIOLATIONS (First Quarter
1996)
Background
A national bank was cited
for violations of 12 CFR 226.18 (b) Truth in Lending ---Amount
Financed, 12 CFR 226.18 (d) Truth in Lending ---Finance Charges and
12 CFR 226.18 (e) Truth in Lending- Annual Percentage Rates in its
Report of Examination (ROE). The Truth in Lending disclosures
for interim construction loans did not accurately reflect the amount
financed, finance charges, or annual percentage rates. The bank was
informed that these violations required reimbursement under 15 USC
1607 (e) (1) Truth in Lending Simplifications and Reform Act and was
provided the policy guide agreed to by the five federal financial
regulatory agencies which summarizes the reimbursement provisions of
the act. The bank made a formal appeal to the ombudsman to determine
1) if the violations of regulation Z actually occurred, and 2) if
the bank had any discretion in calculating the reimbursement
amounts.
Discussion
The bank offers only interim
construction financing loans. Other financial institutions provide
the permanent financing. While 12 CFR 226.17 (c) Basis of disclosure
and use of estimates deals with interim construction loans, Appendix
D of Regulation Z addresses the proper disclosure of multiple
advance construction loans. Since the bank does not provide the
permanent financing for its construction loans, Part I of Appendix D
must be used to estimate the interest portion of the finance charge
and the APR to make disclosures. Part I states:
Part I - Construction Period Disclosed Separately
A. If
interest is payable only on the amount actually advanced for the
time it is outstanding:
- Estimated interest---Assume that one half of the
commitment amount is outstanding at the contract interest rate for
the entire construction period.
- Estimated annual percentage rate---Assume a single
payment loan that matures at the end of the construction period. The
finance charge is the sum of the estimated interest and any prepaid
finance charge. The amount financed for computation purposes is
determined by subtracting any prepaid finance charge from one-half
of the commitment amount.
- Repayment schedule---the number and amounts of any
interest payments may be omitted in disclosing the payment schedule
under 12 CFR 226.18 (g). The fact that interest payments are
required and the timing of such payments shall be disclosed.
- Amount financed---the amount financed for disclosure
purposes is the entire commitment amount less any prepaid finance
charges.
On all of the interim
construction loans the bank's estimated interest was calculated by
multiplying the contract interest rate times the total commitment
times the number of days of the commitment divided by 365. This led
to an overstatement of the interest portion of the finance charge.
The bank disclosed the contract interest rate as the annual
percentage rate (APR), which resulted in an understatement of the
APR. The bank did not add the origination fee (a prepaid finance
charge) to the estimated interest when disclosing the finance charge
and no repayment scheduled was disclosed. The bank disclosed the
amount financed as the total commitment when the prepaid finance
charge (in the form of an origination fee) should have been
subtracted from the commitment amount.
Conclusion
The appeal argued that while
the Regulation Z disclosures had not been accurate, the customers
were fully aware of the cost of obtaining the interim construction
loans. Although the origination fees were disclosed (but not
included in the calculation of the APR or subtracted from the amount
financed), the inaccurate calculations constitute Regulation Z
violations; therefore, reimbursement of the affected accounts will
be necessary.
The appeal requested the
ability to figure reimbursement on the actual annual percentage rate
(APR) versus the disclosed APR. Using the OCC's RE Construction Loan
APR Software program, reimbursement is figured on the proper
disclosure versus the actual disclosure. The Examiner's Guide to
Consumer Compliance includes a question and answer section. Based on
question number 10 after the Truth in Lending Act section, the bank
is allowed an option in figuring reimbursement on multiple-advance
loans. It states:
10. How will disclosures containing
information properly estimated under 12 CFR 226.5 (C), 12 CFR 226.17
(c), and Appendix D be treated for reimbursement determinations and
computations?
Answer- If APR or finance charge is in error
for any reason other than properly made estimate, the determination
of whether the error constitutes a reimbursable overcharge will be
made using the estimated information as disclosed. At the creditor's
option, reimbursement will be based on either:
The
actual amount of loan advances, with consideration given to the
amount and the dates payments were actually made by the borrower,
or;
The
disclosed amounts or time intervals between advances and between
payments.
The basis selected shall be applied, using the
lump sum or lump sum/payment reduction method (at the creditor's
discretion), to all loans of the same type subject to
reimbursement.