Federal Reserve Board Issues Comprehensive Affiliate Rules Under Sections 23A And 23B Of The Federal Reserve Act

For the first time, the FRB published comprehensive proposed, interim final, and final rules (the "Rules") regarding Sections 23A and 23B of the Federal Reserve Act (" Section 23A" and "Section 23B"). As is described below, Sections 23A and 23B govern most transactions between "banks" and their "affiliates". The term "banks" includes all national banks, as well as insured state member and nonmember banks and, for certain purposes, US branches and agencies of foreign banks. In addition, while the OTS separately issues rules for thrifts and their affiliates under Sections 23A and 23B, federal law specifies that the OTS rules for insured thrifts must be at least as strict as the Rules. Thus, the Rules are relevant to all organizations having a bank or thrift as a member, except organizations having only uninsured state banks. The importance of the Rules is derived from the need to maximize efficiencies and competitive advantages to compete successfully in the modern financial services marketplace. Rather than operating banks and their affiliates as separate and distinct enterprises, organizations with banks as a member have increasingly sought ways to coordinate and integrate the resources, products and services of their banks with their nonbank affiliates. The greater geographic and product flexibility afforded nonbank affiliates of financial holding companies under the Gramm- Leach- Bliley Act of 1999 (the "GLBA") will only serve to increase this trend. The Rules for the first time establish a comprehensive regulatory framework addressing the degree to which, and with what regulatory burdens, this coordination and integration may occur. Given the FRB’s preamble statement that it considers Sections 23A and 23B to be "two of the most important statutory protections against a bank suffering losses because of transactions with affiliates," it can reasonably be expected that the FRB will vigorously enforce these provisions. This issue of the Alert seeks to provide greater understanding of this important topic. First, to provide context, the article summarizes the purposes and protections of Sections 23A and 23B. The article then provides further analysis about each component of the Rules.

I. General Protections Of Sections 23A And 23B. Congress passed Sections 23A and 23B to protect a bank from adverse consequences as a result of imprudent transactions with its affiliates, such as mortgage companies, s ecurities firms, and insurance companies. Congress feared that, for example, without some legislative protection, a bank’s parent might cause the bank to support imprudently a floundering affiliate, ultimately resulting in the bank’s failure and adverse consequences to taxpayers as a result of draws upon the FDIC insurance fund. To avoid this result, Section 23A applies quantitative limits and other requirements upon many transactions (called "covered transactions") that result in a flow of funds from a bank to its affiliate, including purchases of assets from, loans to, investments in, and guarantees on behalf of, an affiliate. Section 23B applies more generally to protect all transactions (including service contracts) between a bank and its affiliates by requiring that they be on terms no less favorable to the bank than those the bank could obtain from an unaffiliated third party.

A. The Proposed Rule. By far the most voluminous portion of the Rules are the proposed regulations (the "Proposal"), designated proposed FRB Regulation W, that sets forth the basic framework of how the FRB applies and interprets Sections 23A and 23B. Because the FRB intends Regulation W to be a "single, comprehensive reference tool" for this area, a significant portion of the Proposal mirrors the traditional statutory provisions in, and FRB interpretations of, Sections 23A and 23B. This article will focus on the new insights provided and restrictions applied by the Proposal. Comments on the Proposal are due by August 15, 2001.

Quantitative Limits: Section 23A limits covered transactions to 10% of the bank’s capital and surplus with any one affiliate, and 20% with all affiliates in the aggregate. The Proposal confirms that a bank need not reduce a pre- existing covered transaction to conform to these limitations because its capital subsequently declines or the covered transaction later increases in value. However, the Proposal provides an incentive to banks to reduce such excesses by declaring that a bank may not engage in any new covered transaction if existing covered transactions with any affiliate (not just the affiliate with which the new transaction is contemplated) exceed 10% of the bank’s capital and surplus.

Collateral: The Proposal also provides additional detail as to how to comply with the Section 23A requirement to collateralize certain covered transactions. If a deposit account is used as collateral it must be specially "earmarked" as described in the Proposal. Moreover, the Proposal specifies that certain types of assets are not acceptable collateral, including intangible assets (such as mortgage servicing rights), guarantees, and bank securities. Special rules and deductions also apply if the bank does not have a first priority interest in the collateral. Finally, relaxing the FRB’s historical approach, the Proposal states that, under certain circumstances, the collateral requirements would not apply to the undrawn portion of an extension of credit to an affiliate.

Low- Quality Assets: With respect to low- quality assets, the Proposal maintains the FRB’s traditional exception for renewing or providing additional funding to existing participations, but adds as a prerequisite a new regulatory prior notice requirement.

Timing and Valuation: As to the timing of covered transactions, the Proposal departs from industry practice by providing that Section 23A applies (with certain exceptions) to intraday, as well as overnight, transactions. As to valuation, among other things, the Proposal requires banks to value investments in affiliate securities and purchases of affiliate assets at thegreater of cost or carrying value, resulting in the aggregate amount of a covered transaction increasing if the value of the security or asset increases after the bank acquires it. The Proposal also reduces the flexibility provided by a 1999 FRB interpretation for a bank to accept affiliate securities as collateral.

Bank-Affiliate Merger and Acquisition Transactions: The Proposal also addresses how the Section 23A rules will apply to bank mergers with affiliates and contributions of stock of an affiliate to a bank. Of particular note, with limited exceptions, the Proposal states that if a holding company contributes the stock of an entity to a bank and the entity becomes a bank subsidiary, all liabilities of the entity (not just liabilities to affiliates) will be deemed part of a covered transaction, even if there is a net transfer of value to the bank.

Derivatives: Although not actually proposing provisions, the p reamble to the Proposal makes clear that the FRB is strongly considering subjecting at least certain credit exposures arising out of derivatives to the Section 23A limitations. The Proposal seeks additional comment on, among other things, which derivatives should be treated as loans, as well as appropriate reporting, quantitative and collateral obligations. Based upon responses, the FRB intends to issue a proposal on treatment of derivatives in the future.

Exemptions: The Proposal also sets forth numerous exemptions from the Section 23A requirements. Notably, the Proposal and its preamble both expand the exemption currently located at 12 CFR 250.250 to cover the purchase of any type of loan from an affiliate, and provide restrictions (such as the impermissibility of a bank satisfying its requirements simply by having an affiliate use the bank’s underwriting standards) on its use. Furthermore, while as stated above intraday credits would be considered covered transactions, the Proposal exempts intraday exposures resulting from securities clearing and settlement transactions and payment transactions from the Section 23A requirements. Indeed, it was reported in the May 7, 2001 issue of the American Banker that FRB General Counsel J. Virgil Mattingly statedto the Board of Governors of the FRB during his presentation concerning the Rules that the provisions dealing with intraday transactions are narrowly drafted and are intended to stop only one type of transaction, "a deliberate intraday overdraft made by a bank to an affiliate that needs the funding that day to get through the day."

US Branches/ Agencies of Foreign Banks: To ensure competitive equality between US and foreign banks, the Proposal would apply Sections 23A and 23B to US branches and agencies of foreign banks when they are engaging in transactions with affiliates directly engaged in the US in any of the following activities authorized under the GLBA: insurance underwriting, securities underwriting and dealing, merchant banking, and insurance comp any investment activities.

Definitions: Finally, the last subpart of the Proposal amends certain definitions in Sections 23A and 23B. Of particular note, the Proposal would even make unregistered investment funds affiliates of a bank for purposes of the Proposal if they are advised by the bank or an affiliate and the bank or an affiliate holds more than a 5% voting stake in them. The Proposal also seeks comment as to whether state bank subsidiaries (such as real estate management subsidiaries) that are engaged in activities impermissible for the bank itself but are not financial subsidiaries should be subject to Section 23A’s restrictions. The Proposal also would consider "keepwell" agreements to be covered transactions, and requests comment on how to treat securitizations in which the bank transfers assets to a special purpose vehicle. Finally, the Proposal expands the definition of "low- quality assets" and makes clear that commercial paper is a security for purposes of the application of Section 23A.

B. The Interim Rule. The FRB also published an interim rule (the "Interim Rule") concerning derivative transactions and intraday credit extensions with affiliates to satisfy the GLBA’s requirement that rules be issued concerning these areas by May 12, 2001. The Interim Rule notes that (as described above) the Proposal seeks to address more substantively how these matters should be handled for purposes of Section 23A. Nonetheless, in accordance with the GLBA, the Interim Rule requires banks to adopt policies and procedures to monitor, manage, and control credit exposures from derivative transactions (defined identically to the capital guidelines) and intraday credit exposures to affiliates.

Moreover, the Interim Rule highlights that derivative transactions always have been, and will continue to be, subject to the market terms requirement of Section 23B. Among other things, this latter requirement forces banks to collateralize derivatives with affiliates in the same manner as they would with unaffiliated parties. The Interim Rule also would make certain intraday credit with affiliates subject to Section 23B. The Interim Rule does not become effective until January 1, 2002, but as stated above, the FRB believes Section 23B by its terms currently applies to derivative transactions with affiliates.

C. The Final Rule. The FRB also published a final rule (the "Final Rule") implementing interpretations and exemptions, generally involving a registered broker- dealer affiliate of the bank, for which the FRB sought comment in 1998. One component of the Final Rule exempts from the Section 23A requirements certain loans to third party borrowers who then use the funds to make purchases through or from bank affiliates (the "Loan Exemptions"). The second component expands the ability of a bank to purchase securities from a registered securities affiliate (the "Purchase Exemption").

The Loan Exemptions: As a general matter, the so- called attribution rules of Section 23A dictate that a loan by a bank to an unaffiliated third party is deemed to be a loan to an affiliate of the bank to the extent that the proceeds of the loan are used for the benefit of, or transferred to, that affiliate. However, as an execption to this general rule, the Final Rule includes an interpretation that Section 23A does not apply when the loan proceeds are used to enter into an agency transaction with any affiliate of the bank so long as (1) the securities or other assets purchased by the borrower are not issued by, or sold from the inventory of, the affiliate, and (2) no affiliate retains any portion of the loan proceeds. Moreover, so long as the loan proceeds are used to purchase securities from a registered bank affiliate acting as a broker- dealer or riskless principal, the affiliate can retain a portion of the loan proceeds to pay its commissions. In addition, if a bank has a pre- existing (not merely pre- approved) line of credit with a third party borrower established for other purposes, the Final Rule exempts from the Section 23A restrictions the borrower’s use of the proceeds to purchase securities underwritten or held as principal by a registered broker- dealer affiliate of the bank. The Loan Exemptions become effective June 11, 2001.

The Purchase Exemption: As described at the outset of this article, bank purchases of assets from an affiliate generally are covered transactions, and thus subject to the limitations of Section 23A. Section 23A itself exempts from this restriction bank purchases of affiliate assets that have a readily identifiable and publicly available market quotation. The Final Rule further expands this exemption as to certain securities purchases by a bank from its registered broker- dealer affiliate. Among other requirements, the new exemption requires that the security h ave a "ready market" (as defined by SEC regulation), be eligible for direct purchase by a state member bank (a broader standard than the 1998 proposal), and be "quoted routinely" on an unaffiliated electronic service. Notably, the FRB specifically considered and did not propose exempting from Section 23A limitations (unless the securities are guaranteed by the US) securities issued by an affiliated mutual fund and asset- backed securities issues by an affiliate. The Purchase Exemption also becomes effective June 11, 2001.

III. Conclusion. In its recently published Rules, the FRB provides substantial additional insight into the application of Sections 23A and 23B to transactions between a bank and its affiliates. While some of the positions in the Rules represent a relaxation of the statutory provisions, many of the provisions are likely to increase the likelihood that an unwary institution will be deemed to violate those provisions. In sum, institutions able to navigate prudently and implement the Rules will have a substantial advantage when seeking to coordinate permissibly their bank and nonbank operations to provide integrated services most efficiently and successfully in the new financial services marketplace.

It is our understanding that after the Rules become effective, the staff of the federal bank regulatory agencies will, as part of their subsequent examination of a financial institution, review the institution’s Transactions with Affiliates Policy (or any similar policy dealing with compliance with the requirements of Section 23A and Section 23B) to determine whether the policy has been appropriately revised to conform to the requirements of the Rules.