To state the obvious: a bank is not your typical corporate entity. That is to say, a corporation can engage in a much broader range of activities than a bank, which is restricted to engaging only in those activities which are permissible for its particular charter. For example, banks are limited by statute and by regulation in the types of investments they can make. The regulations contain a laundry list of bank-eligible investments, including obligations of the United States Government, any state or political subdivision thereof, and obligations of government sponsored entities such as Fannie Mae or Freddie Mac. Banks also may invest in obligations determined by their regulators to be permissible as "incidental to the business of banking."
The question presented by BOLI is whether a bank’s investment in life insurance is permissible. Life insurance is not on the laundry list of bank-eligible investments, so on what authority can banks rely? The simple answer is: regulatory fiat. In the latest of a series of regulatory pronouncements going back to 1991, Bulletin 2000-23 (the "Bulletin"), the Office of the Comptroller of the Currency specifically sets forth four situations in which the purchase of insurance has been found incidental to banking and therefore permissible: key person insurance, insurance on borrowers, insurance purchases in connection with employee compensation and benefit plans, and insurance taken as security for loans. The Bulletin emphasizes that the purchase of life insurance, however, must address "a legitimate need of the bank for insurance." The other federal bank regulators have adopted the OCC’s approach..
Thus, BOLI is a permissible investment if purchased for a legitimate purpose. But the federal banking regulators’ determination that BOLI may be permissible for certain purposes does not mean that every bank purchase of BOLI is permissible. For example, life insurance may not be purchased to generate funds for the bank’s normal operating expenses, for speculation, or if the primary purpose is to provide estate planning to bank insiders (unless as part of a reasonable compensation package). Other purposes may be permissible on a case-by-case basis, although there is no guidance as to what other purposes may be approved by banking regulators. Whatever the purpose for purchasing BOLI, banks must be careful to follow (and document that they have followed) the OCC’s guidelines regarding the proper pre-purchase analysis and post-purchase monitoring in order to demonstrate that the purpose is indeed legitimate. The "permissible" label is not a free pass for banks, either – banks must still comply with all other applicable laws, including: tax laws, ERISA, the Federal Reserve Board’s Regulation O, the Interagency Guidelines for Safety and Soundness, and (of course) state insurable interest laws.
The structural elements of any particular BOLI product should be considered to ensure that the investment retains its permissible character. For example, if the BOLI is a separate account product, the bank should consider whether the investments held in that account are bank-eligible. Will the investments in the separate account cause the bank to exceed any applicable aggregate limits for certain types of investments? Will the BOLI product allow the bank to address these concerns without running afoul of investor control limitations? These issues are best considered before the purchase of BOLI, because any post-purchase adjustments could have regulatory and tax implications. If the BOLI product employs a trust to purchase and hold the policies, it is important to remember that a trust cannot engage in any activity on a bank’s behalf that the bank itself does not have authority to conduct. Therefore, before committing to funding a trust to purchase BOLI, bank management must first get comfortable that it could fund a BOLI transaction directly.
While BOLI has been determined by the bank regulators to be permissible for banks, the Internal Revenue Service ("IRS") has recently turned its attention to both BOLI and corporate-owned life insurance ("COLI") products, challenging the validity of COLI products from a tax standpoint, and disallowing deductions related to loan interest incurred on borrowed premiums (so-called "leveraged" COLI deals). Indeed, the IRS has initiated a national-office inquiry into BOLI transactions during tax audits of banks. As a result, a bank must be concerned not only with its primary banking regulator, but also must be prepared to demonstrate to the IRS that its BOLI investment is for a legitimate corporate purpose and is not an impermissible avoidance of taxes.
Recently, courts have refused to recognize the tax consequences of COLI transactions that they have deemed devoid of "non-tax substance" because those transactions did not appreciably affect the taxpayers’ beneficial interest except to reduce taxes owed. In light of this increased scrutiny, banks must consider and document that a BOLI investment has a purpose other than merely tax avoidance.
The recent COLI cases demonstrate that the courts will take a close look at the documentation compiled by the bank as a part of the pre-purchase analysis in order to determine whether the bank had a legitimate business purpose in purchasing the BOLI. With that in mind, it is more important than ever to make sure that the bank has adequate documentation memorializing the consideration given and decisions made prior to purchasing the BOLI.
Not only does the OCC Bulletin require that banks document the consideration given to the BOLI purchase, as well as the monitoring programs in place, but the IRS recently has requested such supporting documentation from some banks. Of course, the same documentation might well satisfy both the IRS during an audit and a banking agency during an examination.
Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.
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