Insider Lending Pitfalls

April 11, 2010

Authored by: Bryan Cave

While the insider lending rules are always a source of headaches, the opportunities for error are greater in bad economic times.  To make matters worse, as the economy slowly improves and the regulatory focus moves from credit quality issues, we are seeing increased regulatory focus on insider lending.

This article is Part One of a two part article on common insider lending problems that we have identified in the industry.  (Read Part Two here.) This installment focuses on the regulatory impediments to renewing insider loans.  While most comments in this article will apply to any bank that is subject to Regulation O, we also discuss a lending limit problem unique to Georgia state banks.

Under Regulation O, any loan to an insider (a) must be made on substantially the same terms as the bank provides on comparable loans to non-insiders and (b) may not involve more than the normal risk of repayment or present other unfavorable features.  These requirements can be called the “arms’ length” and the “normal risk” requirements.

It is easy to think of the normal risk requirement as simply another way of saying that the loan must be on arms’ length terms.  However, neither the Federal Reserve nor the OCC see it that way.  Under current Federal Reserve and OCC interpretations, these are separate and distinct requirements.  Accordingly, a bank can never renew a troubled loan to an insider, even if the bank would have renewed a non-insider loan on the same terms and in the same circumstances.  OCC examiners in the Southeast Region have said that an insider loan cannot be renewed unless it is at least “pass” rated.

In light of these regulatory interpretations, a bank should not renew any non-pass loan for an insider unless the insider first resigns his or her position as an insider.  In that way, the renewal would not be subject to Regulation O.  Of course the original loan approval would continue to be governed by Regulation O, but if the loan when made did not raise Regulation O problems, the fact that it later became troubled should not cause a Regulation O problem so long as the loan is not renewed.

Regulation O also limits total extensions of credit to any insider and the insider’s related interests to 15 percent of the bank’s unimpaired capital and unimpaired surplus.  This total generally may be increased by an additional 10 percent of the bank’s unimpaired capital and unimpaired surplus to the extent the loans are fully secured by readily marketable collateral.

A Georgia statute provides for a similar, but not identical, lending limit for loans to any single person or corporation.  This Georgia statute applies to non-insider loans as well as insider loans.  However, the recent amendment to this Georgia law does not affect how Regulation O is interpreted by the federal bank regulatory agencies, and we have now been advised that the Federal Reserve and the OCC will not conform their interpretations to the GA standard.  It is very important that Georgia banks be aware of this inconsistency when renewing or restructuring loans to insiders.

The purpose of the change to the Georgia lending limits was to allow banks to renew or restructure a loan that the bank otherwise could not originate as a new loan due to changes in the bank’s capital levels.  Under the amended law, the renewal or restructuring of a loan will not be subject to the Georgia lending limits so long as, among other things, no new funds are advanced or a new borrower replaces the original borrower.

The problem is that the federal bank regulatory agencies interpret the Regulation O loan amount limitations as applying to renewals and restructurings of insider loans.  If the bank’s capital levels have declined since the loan was originally made, such that the loan could not now be made within the Regulation O lending limits, the bank may not now renew or restructure that loan.

A Georgia bank will be subject to this Regulation O limit on renewals and restructurings of insider loans, notwithstanding the contrary Georgia law.  The amendment to the Georgia statute to allow renewals of loans in excess of the bank’s lending limits can be relied on only for non-insider loans.