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4000 - Advisory Opinions

Regulation O Violation: Related Interest


February 5, 1981

William M. Lloyd, Regional Counsel

This is in response to your letter of January 13, 1981, to *** of this office, concerning the Regulation O violations noted at bank's most recent commercial examination. You mention that ***, president of ***, has asked you to assist him in resolving these issues. The most recent examination, conducted as of November 18, 1980, indicated violations of § 215.4(a), (b) and (c) of Federal Reserve Regulation O, premised in part on the treatment of *** as a related interest of the president of the bank.

You propose to eliminate the Regulation O violations and possible restrictions under § 23A of the Federal Reserve Act by restructuring the ownership of *** so it would no longer fall within the definition of a related interest or of an affiliate. At present, three of the four principal shareholders of the bank are directors of *** and each owns 25% of its stock. Thus, the company is considered a related interest of each of these three directors under § 215.2(b)(1)(i) of Regulation O. Moreover, because the same bank directors own a majority of the stock of the oil company and constitute a majority of its board of directors, it is considered an affiliate of the bank for purposes of Federal Reserve § 23A. You propose to eliminate the affiliation and the related interest status by having the oil company redeem from the directors all but 3% of each of their stock and to increase the size of the board of directors of that company so that they will no longer represent a majority of its total board. The directors will take an unsecured note of the company in consideration of the stock redemption.

The plan discussed in your letter may or may not eliminate the related interest or affiliate status of ***. You are correct, however, in stating that the divestiture plan does not establish the rebuttable presumptions of control stated in § 215.2(b)(2) of Regulation O. On the other hand, although any director may not be deemed to control the oil company through one of these presumptions, he may be deemed to control if, as a matter of fact, he controls in any manner the election of the majority of the directors or if he has the power to exercise a controlling influence over the management or policies of the company. Thus, if as an absolute matter, the individual does exercise such a power, whether or not pursuant to a rebuttable presumption, *** would be deemed to be a related interest of the director. The same standards would apply in the definition of affiliate for the purposes of § 23A, except that the criteria is bank control of a majority of the company's stock. In addition, the definition of affiliate contains no rebuttable presumptions of control.

Thus, whether *** is an affiliate or a related interest depends on facts perceived over a period of time. Such an analysis would be based, in part, on whether the existence of a debtor/creditor relationship (the unsecured note) would permit the three directors of the bank to exercise a controlling influence over the company's management or policies. In this regard it is noted that we do not know the terms of the note or of the credit agreement. Another factor that might be considered would be the identity of the other directors appointed to the company. If the other directors are viewed as representatives or nominees of the three existing bank directors or otherwise under their influence or control, then the three bank directors acting in concert may still be deemed to be a controlling influence over the management and policies of ***. It is not known at this time whether other directors would be truly independent of the three bank directors.

Although the proposed divestiture plan would not cause us to immediately classify *** as a related interest or affiliate, you should be advised that the removal of *** from this status will not eliminate the Regulation O violations cited in the report. Although future loans to that company may no longer be aggregated with loans to the individual bank director for purposes of the Regulation O lending limit, the existing loans on the books considered violations of the regulation must be paid down to below the lending limit or otherwise strengthened in the case of a loan subject to adverse classification. To rule otherwise would be to permit a loan that was considered an abusive banking practice at the time it was made to remain on the books merely because the status of the borrower or his related interest has changed.

I trust this is responsive to your inquiry.

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