Appeal of Violations of Law (Fourth Quarter 1995)
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)
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.
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.
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.