4000 - Advisory Opinions
Renegotiation of Terms of Original Loan to Director to Permit Higher Return at Maturity
April 15, 1982
This will respond to your letter of March 11, 1982, regarding a letter you received from ***, who is a director of *** wherein *** asked whether the interest rate on a certificate of deposit issued by *** and pledged to secure a loan made to a company controlled by *** in 1978 may be increased at the maturity of such deposit, or whether (as an alternative) a different certificate of deposit in the same principal amount, but issued by a different insured bank, may be substituted as collateral for such loan. The original loan for approximately $174,000 was made in 1978 with interest payable at 10% per annum over a period of nine years and was partially secured by a $100,000 certificate of deposit issued by *** with interest payable at 8% per annum. In essence, *** has requested the bank to renegotiate the terms of the original loan to permit a higher return on the deposited funds serving as collateral for such loan.
The first issue presented is whether the renegotiation of one of the terms of a consummated loan made to a related interest of a bank director is subject to the preferential treatment prohibition contained in section 215.4(a) of Regulation O (12 CFR § 215.4(a)). We conclude that this question must be answered in the affirmative. The prohibition against preferential treatment provided in section 215.4(a) of Regulation O is generally limited to "extensions of credit". It might be argued in the present case that the bank is not actually making any "extension of credit" by modifying the terms of an existing loan and that the prohibition against preferential treatment in section 215.4(a) is therefore inapplicable. Such argument, however, substitutes form for substance and ignores the underlying purposes of Regulation O. For example, assume that a bank makes a loan to a director and that the terms of such loan are determined to be in compliance with the requirements of section 215.4(a) of Regulation O at the time the loan was made. Assume further, however, that shortly thereafter the bank and director "renegotiate" one or more of the key terms of the loan in a manner gives a clear preference to the borrower--such as by reducing the rate of interest, by over extending the payment amortization schedule (e.g., a ten-year automobile loan), by reducing or releasing pledged collateral, by reducing or eliminating payments on principal to provide for a balloon payment, or by any other means of preferred treatment. It must follow that such actions are subject to Regulation O; to hold otherwise would make a mockery of the regulation by placing a premium on form over substance.
Having concluded that the requirements and prohibitions of Regulation O will be applicable to the renegotiation of the terms of extensions of credit previously made by a bank to a director (or any other "insider" covered by the regulation), the only remaining issue is whether compliance with the prohibition contained in section 215.4(a) should be weighed and determined in terms of what would be considered as preferential at the time of the original loan transaction, or whether the renegotiated terms should be evaluated for what would be considered preferential treatment as of the time of renegotiation. We conclude that the loan transaction, as renegotiated, must be evaluated for nonpreferential treatment in terms of other extensions of credit made by the bank to persons not subject to Regulation O at the time of renegotiation. In the present case, therefore, if the bank can determine that it would permit other bank customers with outstanding loans made in 1978 secured by certificates of deposit issued by the bank to renegotiate the terms of such loans by substituting a higher yielding certificates of deposit issued by another insured bank, it would not be considered preferential treatment in violation of section 215.4(a) of Regulation O for the bank to engage in a similar renegotiation with ***. It cannot be overemphasized, however, that the bank must clearly establish that it would engage in a similar renegotiation with any other bank customer similarly situated. In this regard, we note that in the circumstantial context of *** case, the borrowing customer appears to have little or no real negotiating or bargaining power. In short, the bank appears to hold "all the cards", and the borrower has virtually no leverage--except perhaps his position as an "insider". Accordingly, extreme care must be taken in cases of this nature to ensure that the real quid pro quo for renegotiation with *** is not due to or otherwise attributable to the fact that he is a bank director. It must be shown that the renegotiation was transacted upon arms-length basis.
Finally, it should be noted that with regard to any increase in the rate of interest on the certificate of deposit at maturity, section 329.4(h) of this Corporation's rules and regulations requires the maintenance of a 1% interest rate differential between the rate that such deposit has been pledged as security. As a result, as long as the rate of interest on the loan in question remains at 10% per annum, and as long as *** certificate of deposit remains pledged on such loan, the maximum rate of interest payable on such deposit will be 9% per annum.
We trust the foregoing responds to your inquiry.