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Appeal of Violation of Regulation O (First Quarter 2016)

Background

A community bank appealed violations of two parts of Regulation O—12 CFR 215.4(a)(1), “Terms and Creditworthiness,” and 12 CFR 215.8(a) and (b), “Records of Member Banks” (Regulation O)—identified in its most recent report of examination (ROE).

Discussion

The supervisory office (SO) concluded that the bank violated Regulation O because two bank insiders, who were also directors and officers of a nonprofit entity (entity), acted in concert with each other and other individuals of the entity to exercise a controlling influence over the entity’s management or policies. The SO also concluded that the bank insiders had the power individually to each exercise a controlling influence over the management and policies, as evidenced by their roles as directors and officers. Based on these premises, the SO concluded, the entity was a related interest and the bank failed to identify it as such. In addition, the violation stated that the extensions of credit to the entity were not made on substantially the same terms as those prevailing at the time for comparable transactions by the bank with other customers and involved more than the normal risk of repayment or presented other unfavorable features.

The bank acknowledged that the extensions of credit to the entity contained more than normal risk of repayment or other unfavorable features. The bank disagreed, however, with the designation of the entity as a related interest of the bank insiders because, the bank said, the definition of “control” was not met. The appeal contended that a bank insider must control an entity for it to be a related interest. While there are several definitions of “control,” in this circumstance “control” was defined under 12 CFR 215.2(c)(1)(iii) as “Has the power to exercise a controlling influence over the management or policies of the company or bank.” The other two regulatory definitions for “control” related to controlling voting rights or the election of a majority of the board members did not apply given the nonprofit nature and bylaws of the entity.

The appeal argued that the entity was not a related interest of the bank insiders because the insiders did not have the power to exercise a controlling influence over the management or policies of the entity. The appeal asserted the following primary points as evidence:

  • The two bank insiders, as directors of the entity, could not exercise a controlling influence over the entity because they were only two of seven board members.
  • While the two bank insiders were also officers of the entity, neither was granted duties beyond the entity’s bylaws or beyond what is customary for managerial positions. In addition, the bank insiders were under the direct authorization and supervision of the board of directors. As a result, the insiders in their roles as officers of the entity did not exercise a controlling influence.

Conclusion

The Ombudsman conducted a comprehensive review of the information submitted by the bank and the SO and relied on 12 CFR 215, “Loans to Executive Officers, Directors, and Principal Shareholders of Member Banks (Regulation O),” in making a determination. The Ombudsman concurred with the bank that it did not violate Regulation O but noted that the bank’s practices for handling the relationship with the entity were unsafe or unsound. The Ombudsman directed the SO to remove the violations from the ROE, add verbiage regarding unsafe or unsound practices in the ROE, and follow up on the unsafe or unsound practices during periodic monitoring activities and the next on-site examination.

The Ombudsman determined that there was no evidence that the bank insiders met the legal standards to indicate they had the power to exercise a controlling influence over the management or policies of the entity. The SO inaccurately expanded the legal standard for “acting in concert” by implying that because the board as a whole controlled the entity, the bank insiders exercised control by acting in concert with the rest of the board. This was an overly broad interpretation of “acting in concert” that would transform any entity for which a bank insider serves as a director into a related interest, making any loan to that entity subject to Regulation O.

The Ombudsman also determined that the two bank insiders did not exert a controlling influence by acting in concert with each other in their positions as officers of the entity. Even if it is presumed that the two bank insiders acted in concert with each other at board meetings, they were only two directors out of seven, so they did not control the board of the entity through their own votes. The actions of the two bank insiders were not beyond the powers and responsibilities normally attributed to their positions as directors and officers of the entity. Other circumstances must exist for an executive officer to exercise a controlling influence over an entity’s management or policies, such as performing duties beyond what is normal or inherent to the position or performing duties subject to a non-active board of directors.

The Ombudsman determined unsafe or unsound practices existed relative to the approval of loans to the entity without supporting financial information and analysis, as well as lending through the use of excessive overdrafts allowed to remain outstanding over a significant amount of time. The Ombudsman directed the SO to add the following verbiage in the ROE: “The board and management must cease lending through the use of excessive overdrafts and ensure future loan renewals include an analysis of repayment ability. Overdrafts exceeding sixty days must be written-off as required by the “Deposit-Related Credit” booklet of the Comptroller’s Handbook. Lastly, management must immediately update the credit file for the entity with current financial information, document a credit analysis of the relationship, appropriately risk rate the relationship, and allocate a reserve, if necessary. Given the apparent close relationship between the bank and the entity, the board must exercise great care to avoid even the appearance of conflict of interest to uphold the duty of loyalty to the bank.”