4000 - Advisory Opinions
Extensions of Credit Under Regulation O
October 9, 1981
Barbara I. Gersten, Attorney
This will respond to your letter inquiry of August 15, 1981 regarding Regulation O (12 C.F.R. Part 215). Three specific questions are posed.
You ask whether a transaction becomes an extension of credit to covered insiders within the meaning of § 215.3 when the bank's board of directors approves a line of credit, or when the bank issues a commitment to the borrower, or when the borrower makes a draw against the approved line. You point out that § 215.3(a) states in pertinent part that an extension of credit is a "granting'' of a line of credit, while § 215.3(d) indicates credit is extended when the bank enters into a binding commitment to extend credit for the purposes of prior board approval (§ 215.4(b)) and applicable lending limits (§ 215.4(c)). In addition, § 215.3(a)(8) states in part that an extension of credit is any other transaction as a result of which a person becomes obligated to pay money (or its equivalent) to a bank.
Regulation O implements new provisions added as § 22(h) of the Federal Reserve Act (12 U.S.C. § 375b) by Section 104 of Title I of the Financial Institutions Regulatory and Interest Rate Control Act of 1978 ("FIRIRCA"). Section 22(h), made applicable to insured State nonmember banks by 12 U.S.C. § 1828(j)(1), provides in pertinent part, that the term "extension of credit'' has the same meaning assigned to that term in the fourth paragraph of § 23A of the Federal Reserve Act (12 U.S.C. § 371c). Under § 23A, the granting of a line of credit does not constitute an extension of credit. There is no effective extension of credit until a draw is made. The same must apply for purposes of Regulation O.
Thus, the reference in § 215.3(a) of Regulation O to the "granting'' of a line of credit as being an extension of credit is, according to staff of the Federal Reserve Board, inadvertent.* Section 215.3(a)(8), which refers to the borrower incurring an obligation squares with this interpretation. For purposes of prior approval of insider loans in excess of $25,000 (§ 215.4(b)) and for the purposes of determining applicable aggregate lending limits (§ 215.4(c)), an extension of credit is considered made at the time the bank enters into a "binding commitment" to make the extension of credit. This provision is also consistent with the meaning of "extension of credit" under § 23A. A binding commitment is found where the bank commits for a stated period of time (generally thirty to ninety days) to make a loan to the borrower, and the commitment must be honored during that period of time or during the period for which the commitment is renewed. The granting of a line of credit, however, is not the equivalent of making a binding commitment to extend credit, as the bank may refuse to lend under the line of credit. As to a line of credit, a binding commitment on the part of the bank occurs when a draw is made and the borrower becomes obligated to the bank.
You also inquire what information should be noted for the record by a bank's board of directors in approving an extension of credit to an insider, specifically, whether it is sufficient to state the amount of the loan and paraphrase the language of § 215.4(a), which provides in pertinent part, that loans to covered insiders and related interests (1) are to be made on substantially the same terms, including interest rate and collateral as those prevailing at the time for comparable transactions with other persons not covered by Regulation O and not employed by the bank, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. You point out that bankers contend that the board of directors should only be required to approve the loan, with loan officers or committees computing terms and approving future draws against a line of credit in the same manner as for other bank customers not covered by Regulation O.
While § 215.4(b) requires that a bank's board of directors give prior approval for loans or extensions of credit to covered insiders, it is silent on how the board action is to be documented so that compliance with Regulation O may be determined. We have said that the record must reflect more than a mere notice of insider borrowing up to a stated amount, coupled with a recital that the terms of the loan are not to be preferential. At a minimum, the record should reflect the following information regarding the loan to be approved: (1) the name of the borrower, (2) the upper ceiling of the loan, (3) whether the loan is secured or unsecured, (4) the interest rate or range, if possible (i.e., "prime plus"); however, it is permissible, at a minimum, to state the rate is not preferential; (5) the type of loan; and (6) the terms, to the extent possible. The board should be aware of these basic aspects of the loan at the time of approval. Regulation O, which is designed to prevent abusive insider lending practices, places the responsibility for insider loan review squarely with the board of directors which may not, consistent with Regulation O, approve loans the basic terms of which are not known. To lessen the burden perceived by some bankers, perhaps a loan officer or committee could preliminarily review the creditworthiness of the insider and advise the board of the contemplated terms of the loan, should approval be forthcoming.
Importantly, where the board approves a line of credit, a loan officer or committee may approve future draws by the insider without further board action as provided in § 215.4(b)(2), where (1) the line of credit was established within the prior 14 months, (2) the draw is made on substantially the same terms as those prevailing at the time for comparable transactions with persons who are not covered insiders and who are not employed by the bank, and (3) the draw does not involve more than the normal risk of repayment or present other unfavorable features.
Further, you inquire whether the bank or the individual directors may be cited for a violation of Regulation O where the board of directors has approved a million dollar line of credit for each director and executive officer at an interest rate that is clearly preferential, even though no funds have been advanced under the lines of credit.
Technically, under Regulation O, the approval and granting of a line of credit to insiders does not constitute an extension of credit, so that even where the line of credit is clearly preferential when granted, a violation of Regulation O would not be found. Clearly, however, this would constitute an unsafe or unsound practice. At the time a draw is made on the preferential line of credit, a violation of Regulation O would be found. Given this, the board should not approve the granting of preferential lines of credit to insiders.
I hope this is responsive to your inquiry. Should you have any questions regarding the substance of this opinion, please do not hesitate to contact me.