United States: Restrictions On Transactions Between Banks And Their Affiliates In Connection With Securitizations

By Anthony R.G. Nolan

Securitization structures typically involve transfers of assets between a bank and its subsidiaries and may also involve other transactions with entities that control the bank or are under common control with the bank. Consequently, it is important to consider the applicability of the transactions with affiliates rules that are contained in Sections 23A and 23B of the Federal Reserve Act, as amended by the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (collectively, the "TWA Provisions").¹ Taken together, the purpose of the TWA Provisions is to limit the risks to banks (and the federal’ deposit insurance funds) that may arise through transactions between a bank and its affiliates and to limit the ability of a bank’ to transfer to its non-bank affiliates the subsidy arising from the bank’s access to the federal regulatory safety net. Generally speaking, the TWA Provisions limit a bank’s ability to support its affiliates but not the ability of a bank to receive support from its affiliates.²

Section 23A of the Federal Reserve Act regulates affiliate transactions in three major ways. First, the statute limits the aggregate amount of an insured depository institution’s "covered transactions" with any single affiliate (other than a financial subsidiary of the institution) to no more than 10% of the institution’s capital and surplus and limits the aggregate amount of covered transactions with all affiliates to no more than 20% of the institution’s capital and surplus.³ Second, it requires that all covered transactions between a member bank and any of its affiliates be on terms and conditions that are consistent with safe and sound banking practices. Third, it requires that a member bank’s extensions of credit to its affiliates and guarantees issued on behalf of its affiliates be appropriately secured by a statutorily prescribed amount of collateral.4

Section 23B of the Federal Reserve Act provides that "covered transactions" and certain other transactions between a bank (or its subsidiaries) and affiliates of the bank must be on terms and under circumstances, including credit standards, that are substantially the same as, or at least as favorable to the bank as, those that the bank would in good faith offer to non-affiliated companies. Through a non-evasion provision, Section 23A applies to transactions that do not individually violate the enumerated restrictions but that in the aggregate do so.

The term "covered transactions" for purposes of Section 23A encompasses those transactions in which a bank provides credit or funding to an affiliate, such as through a loan or extension of credit by a bank to its affiliate, an investment by the bank in securities issued by the affiliate, the acceptance by a bank of securities issued by the affiliate as collateral for a loan or extension of credit by a bank to any person or the issuance of a guaranty, acceptance or letter of credit by a bank in favor of the affiliate.⁵ For purposes of Section 23B, "covered transactions" consist of (i) all transactions that are subject to the Section 23A definition of that term and (ii) certain other transactions, including asset sales by the bank to its affiliates and payments by the bank to an affiliate under a contract or otherwise.⁶

An "affiliate" of a bank is deemed to include any company that controls the bank or is controlled by the company that controls the bank, any bank affiliate of the bank, any company (including an investment company) that is sponsored or advised by the bank and any company that the applicable regulatory authority determines by regulation or order to have a relationship with the bank or its subsidiary such that "covered transactions" between the bank or its subsidiary and that company may be affected by the relationship to the detriment of the bank or its subsidiary.⁷ Generally, a bank’s non-bank subsidiaries that engage in activities that are permissible for the bank itself are not considered to be affiliates of the bank unless the applicable regulatory authority makes a determination as described in the previous sentence. However, "financial subsidiaries" of a bank are generally considered to be "affiliates" rather than subsidiaries for purposes of Section 23A and 23B, except that transactions between the bank and a financial subsidiary are not subject to the 10% limit on "covered transactions" with a single affiliate.⁸ If the SPV in a securitization transaction were considered to be an "affiliate" of a bank the originating or sponsoring bank’s ability to provide credit or liquidity enhancement to the SPV would be greatly reduced because of the volume limits and collateralization requirements imposed by Section 23A.

A company is generally deemed to control another company if it owns or controls 25% or more of any class of voting securities of the other company (i.e., securities having the right to elect directors of the company) or controls the election of a majority of the directors or is otherwise determined by the applicable regulatory authority to exercise a controlling influence over the management of the company.⁹ A person who owns 25% or more of the equity of a company is rebuttably presumed to have control of that company.¹⁰ To the extent that a financial holding company, under its merchant banking authority, owns 15% or more of the equity of a company and does not trigger the thresholds described above in this paragraph, there are three safe harbors under which its ownership of such a company should not result in its being considered an affiliate.¹¹ The first is satisfied if no director, officer, or employee of the financial holding company can serve as director, trustee, or general partner (or individual exercising similar functions) of the company. The second requires that a person who is not affiliated or associated with the financial holding company own or control a greater percentage of the equity capital in the company than does the financial holding company itself and that no more than one officer or employee of the financial holding company serve as director or trustee (or person exercising similar functions) of the portfolio company. The third is satisfied if a person not affiliated or associated with the financial holding company owns or controls more than 50% of the company’s voting shares and officers and directors of the holding company do not constitute a majority of the directors, trustees or persons exercising similar functions.¹²

Derivative contracts, synthetic loans and synthetic CLOs are not explicitly addressed as "covered transactions" in the statute. However, Federal Reserve Regulation under the Bank Holding Company Act addresses credit exposure arising out of derivative transactions between member banks.¹³ Regulation W treats certain credit derivatives as "covered transactions" for purposes of Section 23A of the Federal Reserve Act and also requires that derivative transactions between banks and their affiliates (other than depository institutions) be on market terms.¹⁴ For purposes of Regulation W, derivatives are defined by reference to the capital guidelines of the federal banking regulatory agencies contained at 12 C.F.R. Part 225, App.III.E.l.a – d.¹⁵

Regulation W requires banks to establish and maintain policies and procedures that are reasonably designed to manage the credit exposure arising from their derivative transactions with their affiliates and also requires banks to impose credit limits on their derivative exposure to affiliates that are at least as strict as the credit limits that they impose on unaffiliated companies that are engaged in similar businesses and are substantially equivalent in size and credit quality as the affiliated counterparties."¹⁶ Such policies and procedures must at a minimum provide for monitoring and controlling the credit exposure arising from the bank’s derivative transactions with each of its affiliates and with all of its affiliates in the aggregate (including by imposing appropriate credit limits, mark-to-market requirements and collateral requirements) and ensuring that the bank’s derivative transactions with affiliates comply with Section 23B of the Federal Reserve Act.¹⁷ In the adopting release for Regulation W the Federal Reserve has stated that it views market terms for derivatives among major financial institutions as requiring daily marks to market and two-way collateralization above a relatively small exposure threshold.¹⁸

Regulation W also treats as "covered transactions" credit derivatives that are the functional equivalent of a bank’s guarantee of an affiliate’s obligations.¹⁹ Such derivatives include credit default swaps between a bank and a non-affiliate that protect against defaults on reference assets that include obligations of an affiliate. They also include total return swaps in which a nonaffiliated counterparty receives payments based on the total return of an obligation of an affiliate of the bank.²⁰ Regulation W does not specify the basis for calculating the covered amount of derivative transactions for purposes of determining compliance with the concentration limits and the collateralization requirements of Section 23A, but the Federal Reserve has stated that it would generally expect the covered transaction amount for a credit derivative to be the notional principal amount of the derivative.²¹ It also does not address the pro-rationing of exposure to an affiliate’s obligations where such obligations represent only a portion of the pool of reference assets with respect to which credit protection is being provided or the use of hedging transactions with third parties to allow a bank to reduce the amount of covered transactions implicated by its use of credit derivatives. In addition, Regulation W does not provide an exception for credit derivatives in which affiliate obligations represent a small portion of the underlying reference assets. However, the Federal Reserve has stated in the adopting release that it intends to interpret Regulation W in such a way as to treat a credit derivative as a covered transaction only to the extent that the derivative provides credit protection with respect to obligations of an affiliate of the bank.²²

The Federal Reserve has stated that it expects to issue a proposed rule that would invite public comment on how to treat as "covered transactions" under Section 23A of the Federal Reserve Act certain derivative transactions that are the functional equivalent of a loan by a bank to an affiliate or the functional equivalent of an asset purchase by a bank from an affiliate.²³ This rulemaking action does not appear to have taken place, but the bank regulatory agencies appear to have adopted positions to address concrete circumstances. For example, the general instructions to Form FRY-8 state that a credit exposure arising from a derivative transaction between an insured depository institution and an affiliate is not subject to the quantitative limits and collateral requirements of Section 23A, but that a credit derivative between an insured depository institution and a nonaffiliate in which the insured depository institution protects the nonaffiliate from a default on or decline in value of an obligation of an affiliate of the insured depository institution is covered under Section 23A as a guarantee by the insured depository institution on behalf of an affiliate.²⁴ In addition, the OCC permits national banks to enter into derivatives transactions with affiliates and subsidiaries that mirror the affiliates’ and subsidiaries’ transactions with (and driven by) their respective customers in order to permit the affiliates and subsidiaries to hedge their positions.²⁵

Footnotes

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