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4000 - Advisory Opinions

Determination of When Transaction is an Extension of Credit Under Regulation O


October 3, 1984

Pamela E. F. LeCren, Senior Attorney

The following is in response to your August 23, 1984 letter to Robert Green, Regional Attorney, FDIC San Francisco Regional Office requesting an opinion as to whether or not a particular transaction involving a director of * * * constitutes an "extension of credit" for the purposes of Federal Reserve Board Regulation O (12 C.F.R. Part 215). Your letter also indicates that should FDIC determine the transaction to constitute an extension of credit, you would like an opinion as to whether or not that extension of credit would be considered to be in violation of § 215.4(a) of Regulation O which prohibits preferential extensions of credit to bank insiders and whether or not the transaction would require the prior approval of the bank's board of directors pursuant to § 215.4(b) of that regulation.

Your letter describes the transaction as follows. In July 1981 the bank made a loan in the amount of $760,000 to * * *, a joint venture formed in June 1980 comprised of * * *, and * * *, a limited partnership, of which * * * is general partner. Under the joint venture agreement, the limited partnership was to contribute 8.24 acres of real estate in * * *, and * * * and * * * were to jointly contribute up to $100,000 cash for preconstruction costs. The loan from the bank was secured by a first deed of trust on certain of the lots to be developed. At the time of the extension of the loan the value of the lots securing the extension of credit was estimated by the bank's chief appraiser to be $1,014,000.

A note and deed of trust were signed by * * * and * * * as "Joint Ventures". The note bore interest at the bank's prime rate plus 1.5% with interest payable monthly until maturity on August 1, 1982. The note was not paid at maturity. A September 22, 1982 review of the collateral on the loan revealed that the market value of the properties securing the loan had declined to $770,000. By December 3, 1982, principal and unpaid interest on the loan totaled $829,616.41 placing the bank in a likely short fall position if the bank was to foreclose upon the collateral. According to your letter, the bank did not consider judicial foreclosure to be a viable alternative. Your letter goes on to state that in the bank's opinion, the only alternative to foreclosure or deed in lieu of foreclosure which would avoid placing a nonearning asset with questionable marketability on the bank's books was to restructure a new loan to the principals of the joint venture.

Over the next six months the bank engaged in a series of negotiations with * * * and the limited partnership to that end. When the bank notified the individual joint ventures, * * *, of its intentions to look to them personally for payment on any deficiency, * * * counsel responded asserting lack of personal liability. On April 28, 1983 the bank offered to waive one half of the past due interest and to extend to all three individuals, as individuals and not as co-ventures, a work out loan at the bank's internally computed cost of funds. At the same time the bank offered to commit to provide construction and permanent financing at a similar rate, subject to normal credit approval and payment of certain fees. The joint venture was dissolved and a new one year note dated June 30, 1983 was taken from * * * personally.

On September 1, 1983 * * * was appointed to the bank's board of directors. According to your letter, the bank did not contemplate * * * election to the board during the course of the work out on the loan. In July, 1984 the promissory note evidencing the work out became due. Neither construction on nor disposition of the lots had occurred. The bank would like to renew * * * note under the previous terms and continue the work out as structured prior to his joining the board of directors.

Your letter indicates that the bank's legal department has reviewed the loan in question and has opined that: (1) the loan is not an extension of credit for the purposes of Regulation O in that it is an indebtedness to the bank for the purpose of protecting the bank against loss as contemplated by section 215.3(b)(4), (2) if the loan in question is an extension of credit, it is not preferential because an interest rate differential granted to a borrower as bargained for consideration for a waiver of legal defenses before the borrower became a director of the bank is not a "difference" in terms and conditions within the meaning of section 215.4(a) of Regulation O, (3) even if a true differential exists, it does not violate the same terms and conditions requirement of 215.4(a) in light of the most closely comparable real estate work out transactions involving the bank and noninsiders, and (4) under California law it is likely that a binding commitment to make this loan was made prior to * * * joining the board of directors and therefore the loan does not require prior approval.

We do not reach the issues of whether or not the instant transaction is preferential and whether the board of directors of the bank needs to give its prior approval to the renewal of the note in question inasmuch as we have determined that the transaction as described above does not give rise to an extension of credit for the purposes of Federal Reserve Board Regulation O. Section 215.3(b)(4)(ii) of Regulation O provides that the term "extension of credit" does not include any indebtedness to a bank for the purpose of protecting the bank against loss or of giving financial assistance to the bank. Although the FDIC has not had a previous occasion to construe this exception in a context as described above, we are prepared to find that the above facts give rise to an indebtedness designed to protect the bank against loss. We come to this conclusion inasmuch as the work out transaction was negotiated by the bank in an effort to protect its position on the loan and avoid foreclosure on collateral that would have placed a nonearning asset of questionable marketability on the bank's books. Based on the above it is our determination that the bank may renew * * * note pursuant to the terms of the negotiated work out regardless of the fact that * * * is presently a director of the bank.

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