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4000 - Advisory Opinions

Affiliation by Common Control Under 23A and Application of Regulation O to an Additional Compensation Package

FDIC-91-78 September 19, 1991 Pamela E.F. LeCren, Counsel

Your August 30, 1991 correspondence to Mr. Douglas H. Jones, Senior Deputy General Counsel, FDIC, has been forwarded to me for review and handling. In your letter you seek an advisory opinion concerning the application of section 23A of the Federal Reserve Act (12 U.S.C. 371c) and Federal Reserve Board Regulation O (12 C.F.R. 215) to a particular set of facts involving your client *** ("the bank").

According to your letter, the bank was cited in its August 31, 1990 report of examination for an apparent violation of section 23A of the Federal Reserve Act in that an extension of credit made by the bank to an affiliate, the *** ("[Company]") did not satisfy the collateral requirements established by section 23A. The bank was also cited for an apparent violation of Federal Reserve Board Regulation O because certain executive officers of the bank who have home mortgage loans from the bank "receive reimbursements from the bank [on their loans] calculated as the difference between the bank's prime interest rate, which is the stated interest rate on their home mortgage loans, and the bank's cost of funds."

You question the regional office's determination that [Company] is an affiliate of the bank. In addition, you characterize the payments received by the executive officers in question as being "additional compensation" that is outside the scope of Regulation O.

After carefully reviewing the facts as presented in the materials forwarded to this office under cover of your August 30, 1991 letter, as well as the arguments contained therein, we concur with the regional office's determination that [Company] is an affiliate of the bank. As to the apparent violation of Regulation O, again it is our determination that the regional office correctly determined that the payments do not qualify as "additional compensation" in the absence of persuasive evidence that the interest differential is not the sole factor the bank takes into consideration in determining the amount to be paid to the executive officers. The basis for our conclusions is set out below.

Applicability of Section 23A

The facts as we understand them to be are as follows. As of the date the extension of credit was made by the bank to [Company], Mr. [A] owned 21.47% of the common stock of the bank's parent holding company, *** ("[Holding Company]") and his son, Mr. [B], owned 7.91% of [Holding Company]. (Their current shareholdings are 19.43% and 10.06% respectively.) [Holding Company] wholly owns the bank. As of the relevant date Mr. [A] and [Mr. B] also each owned one-third of the outstanding interests in [Company]. Based upon these facts the regional office determined that the bank and [Company] are affiliates for the purposes of section 23A as 25% or more of the voting stock of the bank's parent holding company, [Holding Company], and [Company] as commonly owned or controlled by the same persons.

Under section 23A a bank and any given company are considered to be affiliates if the bank (or any company that controls the bank) is controlled directly or indirectly by shareholders who directly or indirectly control the company in question. (12 U.S.C. 371c(b)(1)(C)(i)). Control is deemed to exist if one or more shareholders owns or controls more than 25% of the voting securities of a company. (12 U.S.C. 371(b)(3)(A)(i)).1 Thus, if the shareholders who own or control more than 25% of the voting stock of a bank holding company also own or control more than 25% of the voting stock of another company, that company and the bank which is itself more than 25% owned or controlled by the bank holding company are considered to be affiliates.

Although you concede that an affiliation can exist for the purposes of section 23A based upon the aggregated ownership or control of a company by several persons, your letter argues that the shares owned by individual persons should not be aggregated unless those persons are acting in concert. We do not find your arguments persuasive.

Section 23A has been routinely interpreted to encompass affiliations by common ownership.2 There is nothing in the language or the legislative history of the provision to cause one to conclude that a bank and a company will not be considered to be affiliates unless the common ownership group is acting in concert. The fact that other statutes such as the Change in Bank Control Act of 1978 specifically incorporate acting in concert language is not relevant to an analysis of section 23A. Finally, the Federal Reserve Board has issued an opinion specifically indicating that:

The statutory definition [of affiliate found in (b)(1)(C)(i)] does not require that a familial, contractual, or other relationship exist between the shareholders in order that the company be deemed an affiliate; the only requirement is a commonality of ownership. Thus, any company that is owned by any group of shareholders that controls 25% of the voting shares of a bank is an affiliate of that bank for purposes of section 23A, even if no other relationship exists between the owners.

(FRRS 3--1146.6, February 5, 1990).

Therefore, it is the opinion of this office that the bank and [Company] are affiliated by common ownership for the purposes of section 23A.

Regulation O

According to your letter, the bank makes a housing allowance available to its executive officers which takes the form of an additional compensation package. The purpose of the compensation package is to attract competent bank officers to the local community which is "generally not considered a favorable location." Under the housing allowance the bank periodically pays certain officers additional compensation equal to the difference between the New York prime interest rate (the stated rate on their home mortgages obtained from the bank) and the bank's cost of funds on the home mortgage loans. The terms, including the stated interest rate, are in your opinion substantially the same as those prevailing at the time for comparable transactions by the bank with persons who are not employed by the bank and the loans do not involve more than the normal risk of repayment or present other unfavorable features.

The regional office cited the above described practice as an apparent violation of Regulation O in that the "additional compensation" was in reality a rebate of mortgage interest to the executive officers which, when taken into consideration, causes the loans in question to be preferential. The regional office also noted that the bank previously offered mortgage loans to its executive officers at its cost of funds; that the practice was cited as an apparent violation of Regulation O; and that the current arrangement for "additional compensation" was apparently adopted in lieu of the practice which had been previously cited as an apparent violation. In defense of the practice you state that the payments are made to the executive officers from a separate account and are not "rebated" from moneys received from the executive officers in payment of their loan obligations. You also cite FDIC staff advisory opinion no. 80--17 (July 28, 1980) as authority for finding the bank's practice to be permissible because the payments by the bank are in way of additional compensation which constitutes part of the bona fide salary paid to the individuals in question.

FDIC advisory opinion no. 80--17 does not, in our opinion, provide a safe harbor for a bank from the application of Regulation O in all instances. Opinion no. 80--17 was written in response to an inquiry as to whether a bank may, as part of a compensation package, reduce the interest rate paid on home mortgage loans by its executive officers and directors. The letter indicates that Regulation O is applicable to such instances even though the loan arrangement is part of an employment compensation package. Although the opinion does provide that a bank is free to negotiate the terms of employment for a prospective employee, it emphasizes that those terms may not violate any federal law or regulation. The bank in question was directed to renegotiate the terms of the loans. The letter closes by indicating that the bank is free, if it so desires, to compensate the executive officers and/or directors in question for the alteration of the terms on their loans by raising the individual's salaries as Regulation O does not restrict the payment of a bona fide salary.

We cannot at this time concur with your opinion that the housing allowance package is additional compensation falling outside of the purview of Regulation O. The use of the phrase "bona fide" salary in FDIC advisory opinion no. 80--17 is quite deliberate. The implication being that in order for compensation to be bona fide salary it must have some relationship back to services provided to the bank by the officer or director, i.e., the payment needs to be earned for services rendered. Although compensation yet to be earned can be advanced, the payment cannot be made more than thirty days in advance of when the compensation will be earned or the advance is considered to be an extension of credit under section 215.3(a)(7). In the instant case the bank has not offered any argument that the payments made to its executive officers are based upon anything other than the difference between the bank's cost of funds on the loans to the executive officers and the stated interest rate on those loans. What is more, there is no evidence before the FDIC to show that the executive officers in question could service the loans absent receipt of the payments. These facts taken into consideration along with the fact that the bank was previously cited for making loans to its executive officers at its cost of funds (presumably a preferential rate) forces a conclusion that the bank is continuing to make preferential home mortgage loans to certain of its executive officers.3

1Although paragraph (3)(A)(i) of section 23A provides that a company or shareholder [emphasis added] shall be deemed to have control over another company if certain facts are present, the word "shareholder" is understood to refer to "shareholders" as well. 1 U.S.C. § 1 provides that in determining the meaning of any Act of Congress, unless the context indicates otherwise, words, importing the singular include and apply to several persons, parties, or things. Thus, for the purposes of Section 23A, shareholders are deemed to control a company if the shareholders own, control or have the power to vote 25% or more of any class of voting securities of the company. Go back to Text

2The published opinions you cite to the contrary simply do not involve the issue raised here. Notably, the January 24, 1989 interpretive opinion issued by the Office of the Comptroller of the Currency enclosed along with your correspondence (Opinion No. 471) specifically reserves the possibility of finding an affiliation based upon the aggregation of shares owned by several individuals. Go back to Text

3In his May 15, 1991 correspondence to the bank's president, FDIC Regional Director Kenneth L. Walker specifically requested the bank to present evidence that the interest rate differential is not the sole factor in determining the amount of additional compensation. If the bank presents persuasive facts and information responsive to Mr. Walker's request, the substance of this opinion may change. Go back to Text

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