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Appeal of Policy on Accounting Treatment For Cash Received as Interest on Certain Nonaccrual Loans (Fourth Quarter 1994)

A bank requested a revision in OCC policy establishing the appropriate accounting treatment for cash received as interest on certain nonaccrual loans, to better recognize the true economic reality of those loans. Many of the loans in question have been returned to accrual status, or the bank is recognizing interest income on a cash basis. The bank asked, "At what juncture may a national bank recover into income interest collected and held in reserve as a result of loans being placed on nonaccrual?" The bank also requested reconsideration of OCC's position that a borrower's entire relationship must be paid in full before any contra-interest could be taken into income on any loan forming part of that borrowing relationship.

Background

A few years ago, at the direction of the OCC, the bank changed its accounting method for nonaccrual loans to the cost recovery method. Previously, the bank had maintained a contra-account to capture interest collected on nonaccrual loans. For financial reporting purposes, this account was reflected as a credit balance netted against the bank's reported loan totals. As loans were returned to accrual status, all previously deferred interest was reversed into income, and each loan continued its course going forward based upon its contractual terms. The loans were not written up beyond what management expected to ultimately collect nor were they written up beyond the contractual amount of the bank's investment in the loans. A significant amount of contra-interest reserves associated with these loans remains on the bank's books as a result of the previous accounting treatment. The bank believes it is appropriate for them to recognize as income the interest in the existing contra-reserve account on loans for which the remaining contractual principal and interest are considered to be fully collectible.

A significant number of the loans in question have demonstrated positive performance since inception, but because of certain loan documentation deficiencies were previously designated nonaccrual upon the direction of the OCC under the so-called "performing nonperforming" classification concept. The bank enhanced its documentation with respect to these loans, and subsequently the loans were returned to accrual status. Management feels that the ultimate collectibility of the full contractual amounts was never in doubt. In the bank's view, the contra interest reserves for these loans were created due to a lack of clearly supportable loan file information. Now that the file deficiencies have been addressed, the bank believes it is reasonable to recognize the previously deferred income.

Management believes that the cost recovery method presents a distorted view of their expectations regarding the realization of the bank's investment in certain of these loans (primarily the accruing loans and to a certain degree the cash basis loans.) Also, this method presents the potential for significant earnings boosts at the tail end of the credit relationship, which does not accommodate a matching of revenue recognition with the relationship's economic life. Additionally, management is concerned about the impact that such earnings fluctuations may have on the shareholders and the reaction of the investment community.

Further, the bank believes the OCC-preferred accounting treatment creates a series of anomalies. First, it encourages the bank to request customers to refinance their loans with other institutions. This contradicts the bank's customer-oriented philosophy, which is paramount to the bank's success and the foundation of its business strategy. A second option is to wait until the entire credit relationship is terminated. However, some of these relationships are very important to the bank and may never be terminated. Third, the bank could wait until each individual loan, devoid of a relationship, is repaid in full. This could create a distortion-the ultimate recovery of interest would have no bearing on the economic life of the asset.

The bank's external accounting firm views these loans as analogous to an over-reserved portfolio that requires credit provisions to reduce an overstated loan loss reserve. If the loans are viewed from this perspective, the firm believes that in theory the bank could have recognized the previously deferred interest amounts into income on a cash basis, with an offsetting provision for loan losses, resulting in the same net income effect. If this approach would have been taken, subsequent positive adjustments could have been recorded to reduce the loan loss reserve to recognize the improved quality of the underlying loans and management's true expectations of net recoveries going forward. Accordingly, the accounting firm believes the reversal of the contra account would be acceptable under GAAP in all material respects, given the unique nature of this situation. The bank's ultimate objective is to obtain a solution that will result in an accounting treatment that more closely matches the economic substance of the bank's investment in these loans, based on the specific facts and circumstances involved.

Discussion

The AICPA Bank Audit Guide requires payments received on nonaccrual loans to be applied to principal to the extent necessary to eliminate doubt as to collectibility of the recorded balance of the loan. Otherwise, the interest payment may be recognized as interest income on a cash basis:

If amounts are received on a loan which the accrual of interest has been suspended, a determination should be made about whether the payment received should be recorded as a reduction of the principal balance or as interest income. If the ultimate collectibility of principal, wholly or partially, is in doubt, any payment received on a loan on which the accrual of interest has been suspended should be applied to principal to the extent necessary to eliminate such doubt.

The OCC's Bank Accounting Advisory Series (Topic 2B, Question 18) specifically prohibits immediate recognition of interest payments that have been applied to principal.

Question 18: Can the bank, either now or when the loan is brought contractually current, reverse the application of interest payments to principal?

Staff Response: No. Application of cash interest payments to principal is based on a determination that principal may not be recovered. It should not be reversed when that determination changes. The staff believes that in these situations, the previously foregone interest is recognized as interest income when received. If the loan eventually returns to accrual status, the accounting would follow the guidance in Question 16. (Question 16 states that such accruals should be limited to the contractual rate on the recorded balance. Any payments in excess of that amount should be recorded as recoveries of previous charge-offs, if any, or cash-basis income.) The staff also disagrees with reversing the application of interest payments to principal in these cases because such treatment is analogous to using a "suspense account" to record interest payments when there is doubt as to the collectibility of the recorded principal. Use of this type of "suspense account" was suggested several years ago when interest payments were received on past due loans from Brazil. However, that accounting treatment was rejected as an un-acceptable practice by accounting standard setters.

While the bank used an "interest reserve" account, the substance of the accounting is that the payments were applied to principal. GAAP requires, where there is doubt as to the collectibility of the recorded balance, that the payments be applied to principal, not to an "interest reserve." OCC's position has been that the application of interest payments to principal as required by the AICPA Bank Audit Guide is equivalent to a charge-off. The OCC does not usually permit recoveries of previously charged-off amounts to be recognized until the recovery has been received in cash or cash equivalents.

Conclusion

The Ombudsman's Office granted the bank's appeal. The Office of the Chief Accountant is in process of revising Questions 15 through 18 of Section 2B of the Bank Accounting Advisory Series to reflect the accounting treatment discussed herein. The contra interest reserves associated with the bank's four categories of loans should be given the following accounting treatment:

1) Accruing loans for which full collection of contractual principal and interest was never in doubt by bank management.

Accounting involves the use of many estimates that may later be proven incorrect. An "error" occurs in those situations where the original estimate was materially incorrect based on the facts and circumstances that existed at the time the estimate was made (paragraph 13 of Accounting Principles Board Opinion No. 20.) In this case, because of the degree of hindsight involved, it is difficult to assess whether an error occurred. To conclude that an error occurred, the bank must demonstrate for each non-accrual loan, based upon the facts and circumstances existing at the time the interest payments were received, that there was no doubt as to collectibility of the recorded balance of the loan. To the extent that interest payments should have been recognized as income instead of being credited to the contra interest reserve account, this represents an error. If material, the error should be treated as a prior period adjustment. As a prior period adjustment, previously issued financial statements should be restated.

2) Accruing loans on which collection of principal and/or interest was once in doubt but that doubt has since been removed.

One acceptable method of handling the existing contra interest reserves associated with these loans would be to limit the interest accrual to the result achieved by applying the contractual rate to the recorded balance (net of the contra interest reserve.) Any cash interest payments received in excess of that amount would be recorded as interest income on a cash basis. The contra interest reserve is not recognized until the recorded balance is paid off. Another acceptable method of handling the contra interest reserves associated with these loans would be to recognize interest income based on the effective yield to maturity on the loan. This effective interest rate is the discount rate that would equate the present value of future cash payments (principal and interest) to the recorded amount of the loan (net of the contra interest reserve.) This will result in accreting the amount of interest that was applied to principal over the remaining term of the loan.

3) "Cash basis" loans for which bank management expects to receive full collection of principal but there is doubt concerning full collection of contractual interest.

The contra interest reserves associated with these loans may not be recognized until the loans pay off or they are returned to accrual status per the call report instructions.

4) Other nonaccrual loans.

The contra interest reserves associated with these loans may not be recognized until the loans pay off or they are returned to accrual status per the call report instructions.

OCC does not require a borrower's entire loan relationship to be paid in full before the previously foregone interest may be recognized as income. Current OCC guidance does, however, require repayment of the recorded balance of the individual loan. The refinancing, extension, or renewal of a loan by the bank is not considered repayment.

APPEAL OF VIOLATION (FOURTH QUARTER 1994)

This case was initially summarized in the June 1994 issue of the Quarterly Journal. A revised version is included in this issue to reflect additional actions taken during the third quarter of 1994.

Background

The Office of the Ombudsman received an appeal letter on behalf of a bank which was cited for a violation of 12 CFR 9.12 and Opinion 9.3900. The bank invested trust funds into two mutual funds, which are advised by an investment advisory firm in which a bank director, who also serves on the bank's trust committee, holds a 5.23 percent interest. Neither of the mutual funds nor the investment advisory firm is affiliated with the bank. The funds were invested without obtaining prior written authorization.

First, the bank does not believe that the relationship between the bank and the minority investment by the bank director constitutes an affiliation sufficient to create a problem under Part 9. None of the interests delineated in OCC Regulation, Section 9.12(a) are affected in this case:

(1) Investment of trust funds are not made in stock or obligations of the advisor. Indeed, the fund may terminate its relationship with the advisor upon 60 days notice without penalty at any time.

(2) No property is acquired from affiliates of the bank or their directors, officers, or employees. The adviser does not sell fund shares; such shares are distributed directly by the funds.

(3) The bank receives no advantage from the sale of the funds nor does the advisor.

The bank does not believe that the bank director's minority interest of 5.23 percent is sufficient to create a conflict of interest or a sufficient interest to fall within the prohibitions of Section 9.12. The bank is not purchasing services of the advisor, it is purchasing shares of the funds, which are not affiliated with the bank and in which no bank director has an interest. Neither does the bank believe that the bank director's service on the bank's trust committee, even where he does not participate in such trust investment decisions, should weigh heavily in the decision. Even where a director has a conflict of interest, traditional corporate practice, which is recognized by OCC, holds that by abstaining from any participation in the discussion of, or vote upon, a matter in which such director has an interest, such director may thereby avoid an impermissible conflict of interest under applicable law. The bank cites Alabama Code 10-2A-63, 12 CFR 215.4(b)(i), Section 7.5217(a) and Alabama code, Section 10-2A-21(d).

Second, the bank believes that the provisions of the local law, in this case the Alabama Code, were expressly intended to and do permit the bank to rely on such provisions in order to invest trust funds in mutual funds that are advised by the bank or its affiliates. Alabama Code, Section 19-3-120.1, expressly governs trust investments in mutual funds, and expressly authorizes investments in mutual funds advised by bank affiliates. In the bank's view, Section 19-3-120.1 is more than sufficient for purposes of Section 9.12(a). The absence of any "affiliation" between the bank and the funds raises a question in the bank's mind as to whether reliance on the statutory authorization is even necessary. Although the terms "connection" and "interest" from OCC Regulation, Section 9.12(a) are broad, the bank believes that with respect to trust mutual fund investments by a trust department, the connection or interest must be an "affiliation" in order to even need the protection provided by Alabama Code, Section 19-3-120.1 for purposes of OCC Regulation 9.12.

Finally, the bank believes that recent OCC decisions allowing bank acquisitions of companies that act as advisers to mutual funds expressly recognized that investment companies (mutual funds) are separate and distinct from their advisers (decision to charter J. & W. Seligman Trust Company, N.A., and decision to charter Dreyfus National Bank & Trust Company.) The bank also cites First Union's acquisition of Lieber Asset Management Corporation (93-ML-08-023 and Mellon Bank's acquisition of the Dreyfus corporation (93-NE-08-043 and 93-NE-08-044.)

Discussion

The legal issue raised by this appeal involves the conflict of interest that may exist given the investment of trust assets in mutual funds advised by a company in which a bank director owns stock. In pertinent part, the OCC Regulation, Section 9.12(a), provides:

(a) Unless lawfully authorized by the instrument creating the relationship, or by court order or by local law, funds held by a national bank fiduciary shall not be invested in stock or obligations of or property acquired from, the bank or its directors, officers or employees, or individuals with whom there exists such a connection, or organizations in which there exists such a connection, or organizations in which there exists such an interest, as might affect the exercise of the best judgment of the bank in acquiring the property, or in stock or obligations of, or property acquired from, affiliates of the bank or their directors, officers or employees.

The OCC's regulation is intended to reflect and require for national banks the duty of undivided loyalty, a basic principle of trust law followed throughout the United States . Leading commentators on trust law emphasize the importance of the duty of loyalty and the expected adherence to the high standard. The focus of the duty of loyalty is to deter fiduciaries from getting into positions involving conflicts of interest.

In the present situation, while another company is investment advisor to the mutual funds and not the bank, the relationship of the bank director to the advisory company falls under the circumstances proscribed by the language of 12 CFR 9.12. Here, at least one bank director has some type of ownership in and/or control over the advisory company. The fees received by the investment advisor depend in part on the assets invested in the mutual funds. As such, the owners of the advisor have an interest in the investments in the mutual funds. As directors of the bank, this individual is responsible for directing and reviewing the fiduciary powers of the bank. Accordingly, in the ombudsman's view this situation falls within the scope of the 12 CFR 9.12 prohibition regarding the investment of funds in stock or obligations of organizations in which there exists such an interest as might influence the best judgment of the bank.

As provided by the language of 12 CFR 9.12(a), a self-dealing transaction generally is permissible only when specifically authorized by the trust instrument creating the relationship, where a court order authorized the specific transaction, or where local law allows the otherwise prohibited practice. In this bank's situation, it is not argued that the trust instruments specifically authorize the investment of trust assets in mutual funds that are advised by a company owned in part by directors of the bank. Nor is there any court order authorizing the transactions in question. While the ombudsman is not aware of any Alabama statute that expressly states that a bank may invest trust monies in mutual funds that are advised by a company owned in part by directors of the bank, Alabama Code, Section 19-3-120.1 (1993) does authorize banks acting as fiduciaries to invest in mutual funds that the bank or an affiliate advises or provides other services:

The fact that such fiduciary or any affiliate thereof is providing services to the investment company or investment trust as an investment advisor, custodian, transfer agent, registrar or otherwise, and is receiving reasonable remuneration for such services, shall not preclude such fiduciary from investing in the securities of such investment company or investment trust; provided, however, that with respect to any fiduciary account to which fees are charged for such services, the fiduciary shall disclose (by prospectus, account statement or otherwise) to the current income beneficiaries of such account or to any third party directing investments the basis (expressed as a percentage of asset value or otherwise) upon which the fee is calculated.

Arguably, this section thereby authorizes investment in the mutual funds where a greater conflict exists than that in the bank's situation. Since the Alabama legislature specifically authorized investment in mutual funds where the bank or an affiliate acts as investment advisor or provides other services, it is at least arguable that the statute may include the situation where bank directors own shares in the advisor even though not enough shares to be an affiliate. If the directors owned a greater percentage of the stock (creating an even more direct conflict), and such ownership triggered affiliation between the bank and the advisor, then the conduct would be expressly authorized by the language of the statute. However, we are not aware of any cases interpreting the meaning of the statute, and there is no official legislative history.

Conclusion

Since this is a question of law without any precedential or official legislative history, the Ombudsman's Office chose not to render an immediate decision. The bank was asked to seek a formal opinion from the Alabama attorney general regarding the meaning and intent of the statute. Although not binding for this Office, under the rules of statutory construction, the formal opinions of state attorneys general are normally given considerable deference. While waiting for receipt of that opinion, the bank was advised not to make any more investments in the mutual funds in question and to notify the ombudsman of the attorney general's opinion.

For reasons unique to the State of Alabama , the bank requested as an alternative, and the Ombudsman's Office agreed to accept, a similar ruling from the Alabama Superintendent of Banks. Mr. Kenneth R. McCartha, Superintendent of Banks for the State of Alabama, confirmed the bank's position in a letter dated August 12, 1994, that provided his official opinion regarding the meaning and intent of the Alabama statute. In light of the history of the legislation and the language of Alabama code, 19-3-120.1, Superintendent McCartha concluded that banks located in Alabama, in the exercise of their fiduciary or trust powers, are specifically authorized by 19-3-120.1 to invest in mutual funds where such banks, or their respective officers, directors or shareholders have an affiliation or lesser interest in a mutual funds, or investment advisor, or other service providers to a mutual fund.

Therefore, the Ombudsman's Office concluded, after careful consideration of all the facts, that the most reasonable interpretation of Part 9 provides an exception for the conflict in question. This decision is unique to the facts and circumstances of this situation and local law and in no way establishes OCC precedent regarding conflicts of interest. Notwithstanding this conclusion, the Alabama statute requires the fiduciary to provide disclosure to the current income beneficiaries and/or any third parties directing investment of the basis on which any investment advisory fee or other fee is calculated. The bank did not make these disclosures and therefore the cited violations must stand. While the bank may continue investing fiduciary monies in the mutual funds in question, the appropriate disclosures must be made in accordance with the local law.

APPEAL OF CRA RATING (FOURTH QUARTER 1994)

Background

A formal appeal was received concerning a bank's Community Reinvestment Act (CRA) rating of "Needs to Improve Record of Meeting Community Credit Needs." The bank originally appealed the rating to the district deputy comptroller in the district in which the bank is located. Although substantial changes were made to the content of the performance evaluation (PE), the Needs to Improve rating was upheld during that appeal. The bank's main office and branch are located in a large metropolitan area. The bank's delineated community is made up of predominantly low-and moderate-income census tracts.

The following statement was provided as the Basis for Appeal:

The Bank respectfully submits that the OCC erred in assigning a Needs to Improve rating to the bank's
CRA performance by:

(1) Placing undue emphasis on the bank's loan to deposit ratio;

(2) Placing undue emphasis on the absence of classified loans;

(3) Not placing sufficient weight on the unique characteristics of the bank's delineated community; and,

(4) Ruling that the referral mortgage applicants to an unaffiliated mortgage company does not count toward the bank's fulfillment of its obligations under the CRA.

The bank asked for the following:

The bank respectfully requests that the revised PE be amended to assign the bank a Satisfactory CRA rating, and that the OCC provide the bank with more specific and objective guidance concerning the loan to deposit ratio the bank is expected to achieve and maintain.

The bank goes on to state that "the bank's appeal to the district confirmed what the bank had thought was the case when it received the initial PE - the Needs to Improve rating was driven almost exclusively by the bank's loan to deposit ratio. The OCC's position presently seems to be that the bank is too rigid, in that it continues to use underwriting standards that were appropriate in the early 1980s after the bank's former owners had driven it to the brink of insolvency, but which are no longer appropriate given the bank's current CAMEL 1 safety and soundness rating."

Discussion

The four reasons the bank felt the Needs to Improve rating was assigned were reviewed in detail. An independent examiner, who is considered an expert in CRA, reviewed the examination workpapers and the information presented in the bank's two appeals and went to the bank to review data onsite. He, along with the ombudsman, also toured the local community. Information through the date when the second PE was issued was reviewed.

Each of the four reasons the bank cited for the rating is discussed below.

Placing undue emphasis on the bank's loan to deposit ratio: The bank has historically had a loan to deposit ratio under 20 percent. In the appeal letter, the bank lists the following as special circumstances explaining why the bank has a low loan to deposit ratio:

  1. There is low loan demand in the bank's delineated community;
  2. There is a low level of owner-occupied housing in the bank's delineated community;
  3. The competition for loans and loan participations in the bank's delineated community is substantial;
  4. The large banks are aggressively seeking loans in the bank's delineated community, thereby placing the bank in a difficult competitive posture
  5. The dollar amount of the loans that the bank has lost to large banks has been difficult to replace, particularly in view of the small size of the loans that are being sought by the bank's customers; and,
  6. The banking relationships of the public and private sector institutions in the bank's community have to a large extent been maintained with the large banks, not with small banks like this bank.

Prior to the revised PE being issued by the district, the board of directors amended the loan policy with the intent of making it more flexible. The loan policy changes included:

  • The minimum amount for an installment loan was formally reduced to $500 from the previous $2,000;
  • The requirement for installment loans that applicants have lived at their current address for at least 3 years or moved fewer than 3 times in 5 years was eliminated;
  • The advance rate on new car loans was increased to 90 percent from 80 percent, and the maximum term
    increased from 48 months to 60 months;
  • The requirement that an applicant have a credit bureau record at least 3 years old was removed;
  • For unsecured credit, the requirement that an applicant be an existing customer of the bank was removed;
  • The maximum loan-to-value on real estate loans was increased as follows:
    • First mortgages on investor 1-4 family properties from 70 percent to 75 percent;
    • Home equity lines from 70 percent to 80 percent;
    • Commercial real estate from 70 percent to 80 percent;
    • Cooperative loans from 70 percent to 80 percent;
    • Home improvement loans from 80 percent to 100 percent for loans less than $15M, and from 80 percent to 95 percent for loans greater than $15M;
  • Thirty-year, fixed-rate mortgages were offered for the first time (written to Federal National Mortgage Association guidelines to be sold into the secondary market.)

From reviewing loans it was found that greater flexibility could have been used in evaluating the requests. It is believed that with proper marketing of the changes that the board of directors made in the recent revisions to the loan policy, there are additional legitimate credit needs that can be met by the bank.

We agree too much emphasis was placed on the bank's loan to deposit ratio in the PE. Formulating conclusions on the ratio alone is inappropriate. One must analyze the reasons why the ratio is low and assess the bank's performance with that in mind.

Placing undue emphasis on the absence of classified loans. Inordinate emphasis was not placed on the bank's low level of classified loans. The OCC would never expect a bank to originate extensions of credit that would in any way compromise the overall financial condition of a bank. Such a practice would contravene traditional principles of safe and sound banking. However, the institution was told that based on their strong financial condition that they are in the position to look at alternative methods to meet the credit needs of their community in ways other than direct lending.

Not placing sufficient weight on the unique characteristics of the bank's delineated community. The bank is located in an area that possesses unique characteristics when compared to a number of other community banks. The bank was encouraged to use these unique characteristics to its advantage. The bank had commissioned a consulting firm to code the locations of its loans and deposits. It was found that most were concentrated around the locations of the main bank and branch. Therefore, it was determined that the bank's delineated community was too large. Through further analysis, the bank should be able to fully evaluate its deposit and lending trends in the smaller delineated community. This should enhance the institution's effectiveness in marketing its products, and its ability to communicate to the community the recently revised underwriting standards and product mix. The bank was encouraged to keep education of the bank's community a high priority.

Ruling that the referral of mortgage applicants to an unaffiliated mortgage company does not count toward the bank's fulfillment of its obligations under CRA. The demand for 1-4 family residential loans in the bank's delineated community is low due to the demographics of the area. While the bank has historically referred customers requesting 30-year loans to an unaffiliated mortgage company, the bank recently relaxed its loan policy to begin offering 30-year, fixed-rate mortgages (using FNMA guidelines) to be sold into the secondary market. This is a positive step; however, since the demand for these types of loans is low, the bank was encouraged to identify other ways to assist the bank's community in meeting its housing-related credit needs.

Conclusion

While the four reasons the bank felt the Needs to Improve rating was assigned were being reviewed in detail, a comprehensive reassessment of the bank's overall CRA performance was conducted. After careful review, it was found that a Needs to Improve rating accurately reflects the bank's performance during the period of evaluation covered in the bank's PE. Although there was too much emphasis placed on the bank's loan to deposit ratio in the PE, the overall rating of Needs to Improve was accurate. The rating is based primarily on the bank's performance associated with its limited flexibility in lending decisions.

It is evident that management and the board of directors have taken steps to enhance the performance since the examination. As evidenced by the board of directors' approval of the changes in the loan policy, management and the directors have recognized the bank's ability to be more flexible in its lending standards without sacrificing quality. Although it appears the bank's loan demand is relatively low and the level of market competition has increased because of the movement of large institutions into the bank's area, it is believed that through revising the bank's standards, offering new products, aggressively educating the bank's delineated community, and marketing these products effectively, the bank will find additional credit needs that can be met. The bank is uniquely postured to materially benefit from an elevated level of community development activities. Focused efforts in this area should result in improved CRA performance.