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By: Eric S. Yoon, K&L Gates LLP
This article covers Sections 23A and 23B of the Federal Reserve Act (FRA), which establish certain quantitative limits and other prudential requirements for loans, purchases of assets, and certain other transactions between a member bank and its affiliates. Regulation W, promulgated by the Board of Governors of the Federal Reserve System (Federal Reserve), implements Sections 23A and 23B of the FRA.
The term member bank, as used in Sections 23A and 23B, includes national banks, state-chartered banks, trust companies, and institutions that are members of the Federal Reserve. Member banks also include state-chartered banks that are not members of the Federal Reserve as the Federal Deposit Insurance Act1 applies Sections 23A and 23B to insured state nonmember banks in the same manner and to the same extent as if they were Federal Reserve member banks.
The principal regulatory policy behind these restrictive provisions is to reduce the risk exposure of member banks, which take deposits that are insured, up to a $250,000 limit, by the Federal Deposit Insurance Corporation (FDIC) to the balance sheet and activities of their non-FDIC-insured affiliates. The regulatory objective, in other words, is to shield the taxpayer-funded deposit insurance fund from potential losses that may result from activities of insured depository institutions that may enter into transactions with their affiliates without due regard to conflicts of interest-related concerns.
Overview of Section 23A
Section 23A prohibits a bank from entering into a “covered transaction” with an affiliate if, after the transaction, (1) the aggregate amount of the bank’s covered transactions with that particular affiliate would exceed 10% of the bank’s capital stock and surplus, or (2) the aggregate amount of the bank’s covered transactions with all of its affiliates would exceed 20% of the bank’s capital stock and surplus.
Covered transactions include loans and other extensions of credit to an affiliate, investments in the securities of an affiliate, purchases of assets from an affiliate, and certain other transactions that expose the bank to the risks posed by its affiliates. A bank’s “capital stock and surplus” means the sum of the bank’s tier 1 and tier 2 capital under the risk-based capital guidelines, plus the balance of the allowance for loan and lease losses (ALLL) not included in tier 2 capital, based on the bank’s most recent Call Report.2
Section 23A requires all covered transactions between a bank and its affiliate to be on terms and conditions consistent with safe and sound banking practices (Safety and Soundness Requirement), subject to certain exemptions discussed later in this article, and prohibits a bank from purchasing a low-quality asset from an affiliate.
A low-quality asset includes an asset that is classified or treated as “special mention” or “other transfer risk problems” in an examination report or pursuant to the bank’s or the affiliate’s own internal asset classification system, an asset in a nonaccrual status, or an asset on which payments are more than 30 days past due. In addition, an asset whose terms have been renegotiated or compromised as a result of the obligor’s deteriorating financial condition, and any asset acquired through foreclosure, repossession, or otherwise in satisfaction of a debt previously contracted that has not been satisfactorily reviewed in an examination or inspection, are included within the definition of a “low-quality asset.”3
Extensions of credit to an affiliate and guarantees, letters of credit, and acceptances issued on behalf of an affiliate (credit transactions) must be secured by a statutorily defined amount of collateral, ranging from 100% to 130% of the covered transaction amount. Securities issued by an affiliate and low-quality assets are not acceptable collateral for any credit transaction with an affiliate.
Overview of Section 23B
Section 23B of the FRA requires that certain transactions, including all covered transactions, be on market terms and conditions (Market Terms Requirement). In addition to covered transactions, the Market Terms Requirement applies to:
In the absence of comparable transactions for identifying market terms, the bank must use terms (including credit standards) that are at least as favorable to the bank as those that would be offered in good faith to nonaffiliated companies.
If you are representing a bank that is engaged in what is, or may be, a covered transaction with one of its affiliates, you should consider carefully on behalf of your client the Safety and Soundness Requirement, the Market Terms Requirements, and other limitations applicable to such transaction under FRA Sections 23A and 23B and Federal Reserve Regulation W.
As noted later in this article, severe civil money penalties may be imposed for violating the aforementioned provisions, not only on the bank itself but also on an “institution-affiliated party” (IAP), as such term is defined under 12 U.S.C.S. § 1813(u), which can include an attorney who knowingly or recklessly counsels, or aids or abets, a violation.
Two threshold questions need to be answered in determining whether a transaction is subject to FRA Section 23A/23B and Regulation W. The first question is whether the transaction is between a bank and an “affiliate” of the bank. The second question is whether the transaction is a “covered transaction.”
Definition of Affiliate
Regulation W applies to covered transactions between a bank and a bank affiliate. The definition of affiliate for purposes of Regulation W, set forth in Section 223.2, is broad and includes, among other things:
Definition of Covered Transaction
Once a determination has been made that a bank indeed proposes to enter into a transaction with an affiliate, then the next step is to see whether the transaction is covered under Section 23A or 23B and under Regulation W.
Under Section 223.3(h) of Regulation W, a covered transaction includes:
An extension of credit to an affiliate is broadly defined in Section 223.3(o) of Regulation W as the making or renewal of a loan, the granting of a line of credit, or the extending of credit in any manner whatsoever (examples include advance to an affiliate by means of an overdraft, cash item, or otherwise; a sale of federal funds to an affiliate; a lease that is the functional equivalent of an extension of credit to an affiliate; an acquisition by purchase, discount, exchange, or otherwise of a note or other obligation, including commercial paper or debt securities, of an affiliate; any increase in the amount of, extension of the maturity of, or adjustment to the interest rate term or other material term of an extension of credit to an affiliate; and any other similar transaction as a result of which an affiliate becomes obligated to pay money or its equivalent), including on an intraday basis, to an affiliate.
A bank’s purchase of a debt security issued by an affiliate is an extension of credit by the bank to the affiliate for purposes of Section 23A. Keepwell agreements, under which a bank commits to maintain the capital levels or solvency of an affiliate, also are considered guarantees for purposes of FRA Section 23A and Regulation W. The regulatory presumption here is that credit risk incurred by the bank in such arrangements is similar to the risk incurred by the bank when it issues a guarantee on behalf of an affiliate.
Sections 223.21 through 223.24 of Regulation W set forth valuation and timing rules that are designed to determine the amount of a covered transaction subject to the quantitative limitations and collateral requirements of the rule and the time at which a transaction becomes subject to such limitations and requirements.
Valuation Rules for Credit Transactions
Credit transactions with affiliates generally are valued at the greatest of:
The value of a loan to an affiliate purchased by the bank from a nonaffiliate is the total amount of consideration given by the bank in exchange for the loan and any additional amount the bank could be required to provide to, or on behalf of, the affiliate. Although a bank’s purchase of, or investment in, a debt security issued by an affiliate is considered an extension of credit to the affiliate, these transactions are not valued like other extensions of credit. Purchases of, or investments in, securities issued by an affiliate are valued at the greater of the bank’s purchase price or the carrying value of the securities.
Special Timing Rules for Credit Transactions
A bank is deemed to enter into a credit transaction with an affiliate at the time during the day that the bank becomes legally obligated to enter into the transaction, not at the end of the day on which the loan agreement is signed or the loan is funded. Credit transactions with nonaffiliates generally become covered transactions when the nonaffiliate becomes an affiliate of the bank. If the nonaffiliate becomes an affiliate within one year after the bank has entered into the credit transaction with it, the bank must ensure that the collateral requirements of Regulation W are met promptly after the nonaffiliate becomes an affiliate. In all cases, the transaction must meet the Market Terms Requirement. However, leeway provided by the promptly standard is not available if the credit transaction is made in contemplation of the nonaffiliate becoming an affiliate of the bank.
Loans Secured by Affiliate Securities
Loans by a bank to a third party that are secured exclusively by affiliate securities are valued at the lesser of:
On the other hand, loans by a bank to a third party that are secured by both affiliate and nonaffiliate securities are valued at the lesser of:
Securities of an eligible affiliated mutual fund are not considered securities issued by an affiliate for purposes of this valuation rule, subject to certain conditions designed to ensure liquidity and minimize the use of the exemption as a method of funding affiliates.
Eligible affiliated mutual fund securities are securities issued by an open-end investment company registered with the SEC under the 1940 Act if both of the following are true:
Furthermore, the bank may not exclude affiliated mutual fund securities if it knows, or has reason to know, that the proceeds of the extension of credit will be used to purchase the affiliated mutual fund shares serving as collateral or otherwise will be used to benefit an affiliate.
Valuation Rules for Purchases of Assets from an Affiliate
Purchases of assets by a bank from an affiliate generally are valued at the total consideration given, including liabilities assumed, by the bank in exchange for the asset. The value may be reduced after the purchase to reflect amortization or depreciation of the asset, consistent with GAAP.
Regulation W provides a special valuation rule for a bank’s purchase of a line of credit or loan commitment from an affiliate. A bank must value such an asset at the purchase price paid, plus any additional amount that the bank is obligated to provide under the credit facility. Without this special rule, a company would be able to transfer substantial amounts of unfunded obligations to its affiliated bank without being subject to Section 23A’s quantitative limitations.
Valuation Rules for Purchases of or Investments in Affiliate Securities
As noted above, purchases of or investments in securities issued by an affiliate are valued at the greater of the bank’s purchase price or carrying value of the securities. This approach reflects the risk of continuing exposure to an affiliate through an investment in securities, even if that investment was made at a price below the carrying value of the securities. On the other hand, if the carrying value of the investment declines below the purchase price as the affiliate’s financial condition worsens, the rule limits the ability of the bank to provide additional funding as the affiliate approaches insolvency.
A bank may acquire securities of an affiliate in a transaction that results in the affiliate becoming an operating subsidiary of the bank. These transactions are treated as a purchase of assets and assumption of liabilities of an affiliate. The covered transaction amount for these transactions is the total amount of consideration given by the bank for the shares, plus the total liabilities of the transferred company. The value of the covered transaction may be subsequently reduced to reflect amortization or depreciation of the assets of the transferred company consistent with GAAP and sales of assets of the transferred company.
A bank may not engage in a new covered transaction with an affiliate if the aggregate amount of covered transactions between the bank and the affiliate would be in excess of 10% of the bank’s capital stock and surplus after consummation of the new transaction. Aggregate covered transactions between the bank and all affiliates are limited to 20% of the bank’s capital stock and surplus.
Consistent with GLBA, transactions between a bank and a financial subsidiary of the bank are not subject to the 10% limitation. This exemption from the 10% limit applies to investments by the bank in its own financial subsidiaries. Investments by the bank in the financial subsidiaries of affiliated depository institutions are subject to the 10% limitation. Aggregate covered transactions with all financial subsidiaries and other affiliates of the bank are subject to the 20% limitation.
Consistent with existing interpretations of Section 23A, Regulation W does not require the unwinding of transactions if a bank’s capital declines such that the 10% or 20% quantitative limitation is exceeded. However, new transactions would be forbidden until the quantitative limits could be met.
Any credit transaction between a bank and its affiliate must be secured with the statutorily required amount of collateral.
Under Section 223.14 of Regulation W:
In addition, a bank must maintain a perfected security interest in collateral securing credit transactions. The security interest must be enforceable under applicable law, including in the event of bankruptcy or similar default.
If the bank does not have a first priority security interest in the collateral, it must deduct from the value of the collateral the lesser of:
Note that some transactions are exempt from the collateralization requirements. These include:
Section 223.61 of Regulation W applies Sections 23A and 23B only to transactions between a U.S. branch or agency of a foreign bank and affiliates of the branch or agency engaged directly in the United States in the following activities: fullscope securities underwriting and dealing, non-credit-related insurance underwriting, merchant banking, and insurance company investments. Regulation W also applies Sections 23A and 23B to transactions between a U.S. branch or agency of a foreign bank and any portfolio company controlled by the foreign bank under GLBA’s merchant banking or insurance company investment authorities. Regulation W does not apply to transactions between a U.S. branch or agency of a foreign bank and other affiliates or to transactions between the foreign bank’s non-U.S. offices and its U.S. affiliates.
Special Rules for Derivatives Transactions
Under Section 223.33 of Regulation W, a bank must establish policies and procedures reasonably designed to manage the credit exposure arising from its derivatives transactions with each affiliate and all affiliates in the aggregate. Specifically, the policies and procedures must at a minimum provide for:
In particular, a bank must:
Monitoring and controlling the credit exposure from derivatives transactions includes, at a minimum, imposing appropriate credit limits, mark-to-market requirements, and collateral requirements. The limits and requirements imposed by a bank should reflect the nature, volume, and complexity of its derivatives transactions, and should be approved by the board of directors of the bank or an appropriate board committee.
Under Section 223.33(c) of Regulation W, a credit derivative between a bank and a nonaffiliate in which the bank provides credit protection to the nonaffiliate with respect to an obligation of an affiliate of the bank is considered a guarantee by a bank on behalf of an affiliate and, as such, would be a covered transaction. Such derivatives include:
Special Rules for Financial Subsidiaries
Regulation W treats financial subsidiaries of a bank as affiliates of the bank, in contrast to the general treatment of subsidiaries of a bank as nonaffiliates. A financial subsidiary is any subsidiary of a national or state bank that engages in activities (whether as principal or agent) not permissible for national banks to conduct directly.
Regulation W exempts from the definition of a financial subsidiary a subsidiary of a state bank that engages only in activities permissible for the state bank to conduct directly or activities lawfully conducted prior to December 12, 2002, the date of publication of final Regulation W. However, neither of these exemptions is available for a financial subsidiary of a state bank that engages in principal activities that GLBA requires a national bank to conduct in a financial subsidiary. For example, a subsidiary of a state bank that is underwriting and dealing in bank-ineligible securities would be a financial subsidiary.
A bank’s investment in securities issued by its own financial subsidiary is valued at the greater of:
Exemptions from the Attribution Rule
Regulation W provides certain exemptions from the general rule that treats a transaction with any person as an affiliate transaction to the extent that the proceeds of the transaction are used for the benefit of, or transferred to, an affiliate. Notwithstanding these exemptions, these transactions are subject to the Safety and Soundness and Market Terms Requirements of Regulation W. Please refer to the complete practice note in Lexis Practice Advisor for a comprehensive explanation of exemptions from the Attribution Rule, including:6
Exemptions from the Quantitative Limits and Collateral Requirements
Exemptions from the Quantitative Limitations, Collateral Requirements, and Low-Quality Asset Purchase Prohibition7
Additional Transactions Exempt from the Quantitative Limitations, Collateral Requirements, and Low-Quality Asset Purchase Prohibition include the following:8
Exemption from the Prohibition on Purchases of Low-Quality Assets
The general prohibition on purchases of low-quality assets from affiliates does not apply to certain situations in which a bank seeks to protect its interest in a distressed loan participation. Under Section 223.15(b) of Regulation W, the prohibition does not apply to the renewal of, or extension of additional credit with respect to, a bank’s participation in a loan to a nonaffiliate that was originated by an affiliate of the bank, if all of the following are true:
Section 29 of the FRA9 provides for civil money penalties for any member bank, as well as any IAP with respect to such member bank, that violates Section 23A or 23B of that Act. IAPs are defined broadly to include a director, officer, employee, or agent of a member bank, as well as (under certain circumstances) a consultant or joint venture partner who participates in the conduct of the affairs of the bank, and an independent contractor (including any attorney, appraiser, or accountant) who knowingly or recklessly participates in such violation.
The term violate includes any action (alone or with another or others) for or toward causing, bringing about, participating in, counseling, or aiding or abetting a violation.
Eric S. Yoon is a partner at K&L Gates LLP, splitting time evenly between its New York and Seoul offices. Eric focuses his practice in banking and financial services regulation, cross-border M&A, and financings. He has represented major multinational corporations, global financial institutions, and foreign sovereign entities in the regulatory and transactional aspects of their geographic and product-line expansions as well as strategic divestitures.
To find this article in Lexis Practice Advisor, follow this research path:
RESEARCH PATH: Financial Services Regulation > Bank Activities and Regulatory Enforcement Actions > Holding Company Regulation and Intercompany Transactions > Practice Notes
For an overview of bank lending limits and related regulatory restrictions, see
> LENDING LIMITS AND RESTRICTIONS
RESEARCH PATH: Financial Services Regulation > Financial Services Transactions > Bank M&A, Asset Sales, and Bank Failure > Practice Notes
For a checklist concerning affiliate transactions and compliance with Regulation W, see
> AFFILIATE TRANSACTIONS CHECKLIST FOR INSURED DEPOSITORY INSTITUTIONS
RESEARCH PATH: Financial Services Regulation > Bank Activities and Regulatory Enforcement Actions > Regulatory Examinations and Interfacing with Federal Agencies > Checklists
For a general discussion of Section 23 of the Federal Reserve Act, see
> 1 BANK HOLDING COMPANY COMPLIANCE MANUAL §7.01
RESEARCH PATH: Financial Services Regulation > Secondary Materials
For information about the FDIC, see
> FEDERAL DEPOSIT INSURANCE CORPORATION
RESEARCH PATH: Financial Services Regulation > Bank Activities and Regulatory Enforcement Actions > Regulatory Examinations and Interfacing with Federal Agencies > Practice Notes
1. 12 U.S.C.S. § 1828(j) . 2. See 12 C.F.R. § 223.3(d). 3. See 12 C.F.R. § 223.3(u). 4. 106 P.L. 102. 5. For a complete definition of Affiliate, please see the full practice note in Lexis Practice Advisor under Financial Services Regulation > Bank Activities and Regulatory Enforcement Actions > Holding Company Regulation and Intercompany Transactions > Practice Notes. 6. Exemptions from the Attribution Rule are listed and explained in the full practice note in Lexis Practice Advisor under Financial Services Regulation > Bank Activities and Regulatory Enforcement Actions > Holding Company Regulation and Intercompany Transactions > Practice Notes. 7. For additional explanation of Exemptions from the Quantitative Limitations, Collateral Requirements, and Low-Quality Asset Purchase Prohibition, see the full practice note in Lexis Practice Advisor under Financial Services Regulation > Bank Activities and Regulatory Enforcement Actions > Holding Company Regulation and Intercompany Transactions > Practice Notes. 8. For additional explanation of transactions exempt from the quantitative limitations, collateral requirements, and low-quality asset purchase prohibition, see the full practice note in Lexis Practice Advisor under Financial Services Regulation > Bank Activities and Regulatory Enforcement Actions > Holding Company Regulation and Intercompany Transactions > Practice Notes. 9. 12 U.S.C.S. § 504