A formal appeal was
received concerning three violations of law cited in the bank's
previous report of examination (ROE). Each violation will be
discussed separately.
Violation 1: Legal Lending
Limit with Regard to a Participation Agreement
The first alleged
violation was cited under 12 U.S.C. 84 and 12 CFR 32, the law and
regulation governing lending limits. 12 U.S.C. 84 --- Total Loans
and Extensions of Credit, States the following:
The total
loans and extensions of credit by a national banking association to
a person outstanding at one time and not fully secured as determined
in a manner consistent with paragraph (2) of this subsection, by
collateral having a market value at least equal to the amount of the
loan or extension of credit shall not exceed 15 per centum of
unimpaired surplus of the association.
According to 12 CFR
32.107 (a) -
Sale of loan Participations (as it
was in effect at the time of the transaction):
When a bank
sells a participation in a loan or extension of credit, including
the discount of a bank's own acceptance, that portion of the loan
that is sold on non-recourse
basis will not be applied to the bank's lending limits. In
order to remove a loan or extension of credit from a bank's lending
limit, a participation must result, in a pro rata sharing of credit
risk proportionate to the respective interests of the originating
and participating lenders. This is so even where the participation
agreement provides that repayment must be applied first to the
shares sold. In that case, the pro rata sharing may only be
accomplished if the agreement also provides that, in case of a
default or comparable event defined in the agreement, participants
shall share in all subsequent repayments and collections in
proportion to the percentage of participation at the time of the
occurrence of the event.
The write-up in the ROE
of the above violation of law states the following;
A legal
lending limit violation was included in the ROE under the above
cites because the bank sold a participation on the day a loan
originated using a participation agreement that did not require a
pro rata sharing of risk in the case of default. Instead, the bank's
participation agreement gives the purchaser the right to have
proceeds distributed on a pro rata basis.
The bank's response to
the ROE included the following:
The board of
directors respectfully disagrees with the examiners' opinion that
this a violation of law. The participant agreement has been in use
by the bank since 1990. The OCC has reviewed participations sold
(i.e., another borrower) during prior extensive examinations,
although the purported wording problem within the agreement was
never identified. As a means of resolving differences, paragraph 9
of the participation agreement has been revised. The revised
paragraph was mailed to an OCC attorney by the bank's attorney.
In the OCC's
response to the bank's response the following was said:
The board
disagrees with this violation, stating that the participation
agreement has been used by the bank since 1990. This violation was
discussed between bank counsel and an OCC attorney. As a result,
corrective action was taken on the loan. In further review of the
bank's loans, the OCC found that the participation agreement with
the other borrower (listed in the bank's response) also contains the
inappropriate language.
The participation
agreement contains the following language:
1.
The participant shall not be obligated to purchase
participations in loans. If it purchases any participation, the
participant shall participate and share proportionately with the
originator in each loan in which it participates. The participant's
proportionate share of any loan at any time shall be determined by
dividing the principal amount of this participation by the total
principal amount of such loan then outstanding. Except as provided
in paragraphs two and three the participant shall share
proportionately in any payments received from a borrower with
respect to a loan and shall be proportionately secured by any
collateral and the provisions of any notes and related agreements
and documents. The proceeds of any collection, liquidation, or
disposition of collateral securing any loan shall (after making any
lawful allowance for expenses) be applied, first, to the payment of
interest on such loan and next to payment of the principal of such
loan.
This language in itself is
clear and provides for a pro rata sharing of risk. However, other
provisions of the agreement are relevant.
2.
If this X is checked, so long as no Event of termination has
occurred and is continuing under the terms of a particular loan, any
payments received from or for the account of the borrower that are
in excess of amounts needed to pay interest on such loan shall be
paid to the participant and shall reduce its proportionate share.
Paragraph number 15
states, "the term 'Event of Termination' means, as to any loan, the
earliest of the following events: (i) the occurrence of any event of
default as defined in the loan documents evidencing that loan; (ii)
demand for payment of that loan; (iii) commencement of foreclosure
or repossession of any collateral securing that loan."
Therefore, prior to
default, a LIFO schedule has been established with respect to
payments received that exceed the amount of interest owed. This
provision is consistent with a pro rata sharing of risk since the
LIFO schedule is permitted only until the loan goes into default. As
a general matter, payments may be allocated in any manner agreed to
by the parties prior to default, but any loss must be shared on a
pro rata basis once the loan is in default.
Paragraph 1 of the
participation agreement clearly defines a pro rata sharing agreement
except as provided in paragraphs 2 and 3. Paragraph 2, which was
executed, states that as long as no event of termination has
occurred any payments received from or for the account of the
borrower that are in excess of amounts needed to pay interest on
such loan shall be paid to the participant and shall reduce its
proportionate share. This is written in accordance with the
regulation, as stated above. Paragraph 3 discusses the loan
documents, which will be provided to the participant and is not
relevant to the pro rata issue. Paragraph 9 of the
participation agreement somewhat clouds the pro rata agreement. It states:
9. After an Event of
Termination (as defined in paragraph 15), the participant shall have
the right:
(i) to request
by written notice to the Originator, that any payments, collections,
and proceeds of collateral for the related loan be applied to the
payment of such loan (if such payments, collections and proceeds are
so applied, then, subject to final payment thereof, the Originator
shall promptly remit to the Participant the amount o the
Participant's proportionate share thereof or apply such amount in
payment of any amounts which may be due to the Originator from the
Participant);
(ii) if it
holds, alone or together with other Participants, more than 50
percent of a loan, to direct (acting alone or with such other
participants) that the Originator declare default under the Loan
Documents evidencing that loan, exercise collection rights with
respect to any collateral for that loan and foreclose against or
accept a transfer in lieu of foreclosure of such collateral; and,
(iii)
prospectively revoke by written notice to the originator, the powers
and authorities granted to the Originator in paragraph 7, but only
with respect to the extent of the Participant's participation in
that loan. Notwithstanding such revocation, the Originator shall
thereafter have the power, authority and privilege (but not the
duty) to complete, or to initiate and complete, any act which the
Originator had initiated or become committed for, at or prior to the
time of receipt of such notice, or any act which in its opinion
might, if omitted or abandoned, expose the Originator to any risk of
legal liability. Such revocation shall not effect or impair the
Originator's right to act in its own interest or in the interest of
any of the other participants in such loans.
The above paragraph
somewhat clouds the pro rata agreement.
The ombudsman agrees
that paragraph 9 of the participation agreement is not clear. The
ambiguity centers around whether the word "loan," prior the
parenthetical phrase, is in reference to the entire extension of
credit or just the participation purchased. In an attempt to
understand the bank's interpretation of the participation agreement,
the ombudsman planned to review the manner in which the participant
had been treated in the event of default. However, the bank did not
have any defaults on loans using this particular participation
agreement.
Due to the ambiguous
language in the participation agreement and his inability to know
the true intent of the language in Paragraph 9, the ombudsman does
not feel certain that a violation will not be cited. The bank's
decision to reword the participation agreement to remove any
ambiguity in the document is consistent with safe and sound banking
practices and will provide a safeguard for both the bank and future
participants.
Violation 2: Legal Lending
Limit with Regard to Combining Loans to Separate
Borrowers
The second violation of
law was cited under 12 U.S.C. 84 (a) (1)-Total Loans and Extensions
of Credit, and 12 CFR 32.5(a)(1)(i) --- Combining Loans to Separate
Borrowers. According to the relevant passage of the law:
The total
loans and extensions of credit by a national banking association to
a person outstanding at one time and not fully secured, as
determined in a manner consistent with paragraph (2) of this
subsection, by collateral having a market value at least equal to
the amount of the loan or extension of credit shall not exceed 15
per centum of the unimpaired capital and unimpaired surplus of the
association.
The regulation states
the following:
General Rule.
Loans or extensions of credit to one person will be attributed to
other persons, for purposes of this part, when (I) the proceeds of
the loans or extensions of credit are to be used for the direct
benefit of the other person or persons.
Nine instances were
cited where the bank violated the above legal lending limit statute
on one credit relationship. The first six cites were a loan to one
company, where participations were being bought and sold. The
calculations provided in the examiners' write-up deducted an
ineligible intangible, goodwill the bank acquired after the purchase
of a failed institution. The last three instances cited included a
combination of the loan to the company and a loan to an individual.
The bank's response to
the ROE states that the board agrees with three of the nine legal
lending limit violations. The bank does not agree with four of the
six violations that involved the individual company and that derived
from the bank including the goodwill it received at the time of
purchase of a failed bank in its capital figures. The bank's reply
goes on to state that:
According to
12 CFR 3, Appendix A, footnote 6, "The OCC may not require national
banks to deduct goodwill that they acquire, or have previously
acquired, in connection with supervisory mergers with problem or
failed depository institutions. Generally, this determination will
be made by the OCC on a case-by-case basis at the time of the merger
approval."
At the time of the loans
in question, Appendix A to Part 3 was relevant only to the
determination of the capital adequacy of the bank. At that time,
Appendix A was not the calculation used to determine capital for the
bank's lending limit or for other statutory purposes. In setting
forth the determination of capital for statutory purposes, 12 CFR
3.1(c) (1) defines surplus as the sum of capital surplus; undivided
profits; reserves for contingencies and other capital reserves
(excluding accrued dividends on perpetual and limited life preferred
stock); net worth certificates issued pursuant to 2 U.S.C. 1823 (I);
minority interests in consolidated subsidiaries; and allowances for
loan and lease losses; minus intangible assets. Therefore, it was
never an option for the OCC to allow the bank to include goodwill in
its calculation of the legal lending limit.
In reference to
combining the company debt with that of an individual, the write up
states:
A violation
occurred when the bank advanced money to an individual. The
individual then lent the funds to the company to buy land. According
to 12 CFR 32.5 (a)(1)(I), loans to one person are attributed to
another when the proceeds of the loan are used for the direct
benefit of another. As the loan to the individual directly benefited
the company, the loans are combined for lending limit purposes.
The ombudsman reviewed
the combination of the company loan with the individual loan and
concluded that the loans should be combined for legal lending limit
purposes, because the loan to the individual directly benefited the
company.
Based on the above
discussion and conclusions, the violation was correctly cited in the
ROE.
Violation 3: Loans to Executive
Officers of Banks --- Preferential terms Prohibited
The third violation of
law was cited under the following laws and regulation:
12 USC 375a(1)(b) - General
Prohibition; Authorization for Extension of credit; Conditions for
Credit
Except as authorized
under this section, no member bank may extend credit in any manner
to any of its own executive officers. No executive officer of any
member bank may become indebted to that member bank except by means
of an extension of credit, which the bank is authorized to make
under this section. Any
extension of credit under this section shall be promptly reported to
the board of directors of the bank, and may be made only if ---
(B) It is on terms not more favorable than those afforded
other borrowers;
12 USC 375b (2)(A)
-Preferential Terms Prohibited
A member bank may extend
credit to its executive officers, directors, or principal
shareholders, or to any related interest of such a person, only if
the extension of credit-
(A) is made on
substantially the same terms, including interest rates and
collateral, as those prevailing at the time for comparable
transactions by the bank with persons who are not executive
officers, directors, principal shareholders, or employees of the
bank;
12 CFR 215.4(a) (1) ---General
Prohibitions
(a) Terms and
creditworthiness. No member bank may extend credit to any of its
executive officers, directors, or principal shareholders or to any
related interest of that person unless the extension of credit:
(1) Is
made on substantially the same terms (including interest rates and
collateral) as, and following credit underwriting procedures that
are not less stringent than, those prevailing at the time for
comparable transactions by the bank with other persons that are not
covered by this part and who are not employed by the bank;
12 CFR 215.5 (d) (2)
-Additional Restrictions on Loans to Executive Officers of Member
Banks
(d)
Any extension of credit by a member bank to any of its executive
officers shall be:
(2) In compliance with the requirements of 215.4 (a) of this
part;
The write-up in the ROE
of the alleged violation of law states the following:
The bank
renewed two loans to the chairman of the board on preferential
terms. These non-residential loans were originally extended with a
variable interest rate at national prime. The loans are unsecured
and do not have a structured repayment plan. The chairman's
financial condition no longer warrants these terms. The bank was not
able to provide documentation showing a comparable transaction with
a non-insider.
During the
exit meeting, the bank provided a list of other borrowers who have
loans at the prime rate. However, these loans are not comparable for
one or more of the following reasons: stronger financial condition;
higher internal risk ratings; secured; or on an established
repayment program.
The bank's response to
the ROE stated the following,
During January
1994, a comparable credit was "Another Borrower." The OCC examiners were shown
this credit during the September 15, 1994 Exit Meeting; however,
they stated it was not a comparable loan. The bank and the Board of
Directors strongly disagree with the opinion of the examiners.
"Another Borrower" was a risk rated 2 credit with 1992 wages of
$137M and was an unsecured borrower. His $120M term note called for
annual principal payments of $12M and semi-annual interest payments.
"Another Borrower's" $50M revolver set forth semi-annual interest
payments. The main difference between the COB's and "Another
Borrower's" situation at the bank is the COB has a depository
relationship and "Another Borrower" has none. COB maintained average
depository balance of approximately $200M.
In the OCC's response to
the bank's response the following was stated,
You state that
you do not believe a violation of the above cites has occurred. You
offer the "Another Borrower" credit as an example of a comparable
loan for COB's loans. We have determined that "Another Borrower's"
credit quality differs from COB. "Another Borrower's" note requires
annual principal payments of $12M/year and semi-annual interest
payments. COB's loans had no scheduled principal payments and only
required semi-annual interest payments. "Another Borrower's" credit
was internally rated "2" at the time of renewal. In addition,
"Another Borrower's" leverage position of .09 was less than COB's."
In turn, the bank
responded, stating:
The board
disagrees with the OCC's assessment of the two credits. First,
Attachment1 to the OCC response was dated June 1993, which was based
upon 1992 financial information. "Another Borrower's" and
COB's December 1993 financial statements both reflect leverage
positions that risk rate 1 on the worksheets. Therefore, the OCC's comment
"Another Borrower's" leverage position of .09 was less than COB" has
no substance."
During the exit meeting with
the examiners the bank supplied the examiners with a list of six
loans that the bank felt were comparable. On the list the bank
footnoted that the COB maintained $140M on deposit at the bank.
The Ombudsman's Office
requested the average balances maintained by the six comparable
borrowers at the time the violation was cited. Four of the six
borrowers did not maintain a deposit account at the bank, one
borrower maintained an average balance of $3M one borrower
maintained an average balance of $111M. The loan to the individual
who maintained the $111M balance only totaled $14M versus the COB's
debt of approximately $170M. Due to the amount of debt outstanding
the ombudsman did not feel that the two debts were comparable.
In reviewing the
"Another Borrower's" debt, whom the bank felt was most comparable,
the ombudsman reviewed the four aspects listed in the violation as
reasons why the loans are not comparable (i.e., stronger financial
condition; higher internal risk ratings; secured; or on an
established repayment program). In addition, there was another loan
which the ombudsman felt was somewhat comparable, so the same four
features were reviewed on that loan as well. While the ombudsman did
not feel that either of the two borrowers reviewed were exactly
comparable, he did see similarities. Each of the credit has a "high"
credit grade with one of the non-insider borrowers having an
internal risk rating of "1" and the other non-insider and the COB
debt each risk-rated a "2." Each of the two non-insider borrowers
was on a set repayment period of time. The chairman's debt was not
on a set repayment plan. Neither of the non-insider borrowers had a
deposit relationship with the bank.
In reviewing all aspects
of the non-insider credits, the ombudsman felt the greatest
difference was the lack of an established repayment plan. However,
the ombudsman feels that the lack of an established repayment plan,
as a point of preference, is somewhat mitigated by the deposit
balances the chairman maintains at the bank. If deposit balances are
included in making pricing decisions, documentation evidencing this
should be contained in the file at the time each loan is granted.
Since two loans are rarely exactly the same, the statute provides
for a judgmental window of flexibility in comparing credits to be
"on substantially the same terms." Although there are some
differences between the non-insider borrowers and the COB, they are
not substantial enough to conclude that the COB's extensions of
credit are preferential. Further, the ombudsman did not find
evidence that these loans represented an attempt by the COB to abuse
his position as an insider of the bank. Therefore, the violation of
law will not be cited.
Although the terms of
two loans are seldom exactly the same, it is imperative that a bank
avoid the appearance of preferential insider lending. A
comprehensive assessment of compliance with applicable statutes,
including all insiders' related laws and regulations, should be an
integral part of the underwriting process when lending to bank
insiders.
The bank's decision to
place the COB's debt on a defined repayment plan represents a sound
banking practice.
APPEAL OF VIOLATION OF LAW (Fourth Quarter
1995)
Background
A bank appealed to the
ombudsman for relief from cited violations of 12 U.S.C. 29 in a
recent report of examination. Beginning in 1985, the bank foreclosed
on several tracts of real estate. When the real estate was sold by
the bank, a percent of the mineral interests was retained in an
effort to recover loan losses. The bank is currently recovering
approximately $2,000 per month form the mineral interests retained
by the bank. To date, the bank has recovered $184,000, or
approximately 18 percent.
Discussion
The mineral interests
are real estate under applicable
Texas law. See e.g. TEX BUS. &
COM. CODE ANN. 9.319
(1995); Hager v. Stakes, 294 S. W. 835 (
Tex. 1927); Sheffield v. Hogg, 77 S. W.2d 1021
(Tex.1934); McBride v. Hutson, 306 S.W.2d 888 (
Tex. 1957).
As such, they are subject to the five year holding period
restriction imposed by 12 U.S.C. 29. Upon application by the bank,
the OCC may approve the bank's continued possession of real estate
mortgaged to it as security for debts previously contracted for a
period longer than five years, but not to exceed an additional five
years. The 10-year holding period has expired for the properties, it
is possible for the OCC to grant extensions of the holding period,
if (1) the bank has made a good faith attempt to dispose of the
properties within the five year period, or (2) disposal within that
period would be detrimental to the bank.
Conclusion
The ombudsman decided
that the violations of law cited in the report of examination were
valid. He advised the bank to work with its supervisory office to
develop a plan for ultimate disposition of the mineral interests
which will enable it to maximize its recovery of these charged-off
assets.