FRB Issues Comprehensive Affiliate Rules under Sections 23A and 23B of the Federal Reserve Act

The FRB published comprehensive final and proposed 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 generally 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.

Congress passed Sections 23A and 23B to protect a bank from adverse consequences as a result of imprudent transactions with its affiliates, such as holding companies, mortgage companies, securities 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.

By far the most voluminous portion of the Rules are the regulations (the "Final Rules"), designated Regulation W, that set 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 Alert focuses on the FRB’s "gloss" on the statutory provisions. The Final Rules become effective April 1, 2003, with a limited compliance transition period for transactions completed before the Final Rules are published in the Federal Register and a limited grandfather for certain asset purchases and other transactions.

The Final Rules further define the "procedural" aspects set forth in Section 23A, including the quantative limits, collateral, valuation, low quality assets and exemptions.

Quantitative Limits: Section 23A generally 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 Final Rules confirm 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. Moreover, unlike the proposal, if a bank exceeds the 10% threshold as to any affiliate the bank is only prevented from engaging in any new covered transaction with that particular affiliate (the proposal would have precluded any new covered transaction with any affiliate under that circumstance).

Collateral: The Final Rules provide additional detail as to how to comply with the Section 23A requirement to collateralize certain covered transactions. The Final Rules also expand the definition of "obligations secured by the US" for these purposes to cross-reference the FRB’s Regulation A, which thereby includes FNNA and FHLMC securities. The term does not, however, include VA or FHA loans. If a deposit account is used as collateral it must be specially "earmarked" as described in the Final Rules. Moreover, the Final Rules specify 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 Final Rules state that the collateral requirements would not apply to the undrawn portion of an extension of credit to an affiliate, so long as the bank has no legal requirement to advance funds until the collateral requirements are satisfied.

Valuation: The Final Rules require banks to value investments in affiliate securities and purchases of affiliate assets at the greater 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.

Low-Quality Assets: With respect to low-quality assets, the Final Rules expand the statutory definition to include any asset classified by the bank’s internal system as a classified item, or any asset classified by an examiner as an "other transfer risk problem." The Final Rules also include a process (including notice to a federal regulator) for extending or renewing loan participations involving problem loans.

Exemptions: The Final Rules also set forth numerous exemptions from the Section 23A requirements. In addition to those described below, the Final Rules make clear that if a loan or other covered transaction is only partially secured by Treasuries or other eligible collateral, the covered transaction will be exempt to the extent of that coverage (i.e., the covered transaction need not be fully secured for any exemption to apply). Moreover, while a bank’s purchase of debt securities (including commercial paper) of an affiliate is generally subject to Section 23A, a purchase of affiliate debt from a nonaffiliate in a bona fide secondary market transaction is not. Finally, unlike the proposal, the Final Rules provide an exemption for a bank’s purchase of securities from a securities affiliate if the bank is acting exclusively in a riskless principal capacity.

A Section 23A transaction only occurs with respect to transactions between a bank and its affiliates. The Final Rules further clarify and expand upon the definition of "affiliate."

GLB Financial Subsidiaries: The Final Rules define a financial subsidiary of any bank as a subsidiary engaged in (almost) any activity not permissible for a national bank, and subject financial subsidiaries to virtually all of the Section 23A restrictions (the 10% single entity covered transactions limit does not apply). Despite protests by the FDIC and state banks, the Final Rules apply this national bank permissible standard to state bank subsidiaries, with two exceptions: (i) subsidiaries engaged in activities the parent state bank could perform directly, and (ii) subsidiaries established prior to the publication of the Final Rules in the FederalRegister. Thus, equity securities subsidiaries, and other subsidiaries using the FDIC’s authority to engage in activities under pt.362, established after the Final Rules are published would now be subject to Section 23A. Moreover, while a financial subsidiary generally is not exempt simply because it is engaged solely in agency activities, the Final Rules provide an exemption for national or state bank subsidiaries that engage solely in insurance agency activities. The Final Rules do not, however, subject federal savings bank subsidiaries to the financial subsidiary rules, and do not apply to companies controlled by a GLBA private equity fund, unless the holding company controls the private equity fund. For Section 23A purposes, at the time of acquisition financial subsidiaries subject to the Final Rules are valued at the greater of: (i) the amount paid by the bank for the security; and (ii) the carrying value of the security.

Other GLB Activities: The Final Rules also create a presumption that a merchant banking investment or insurance company is an affiliate of a bank for purposes of Section 23A if the holding company owns 15% or more of the equity capital of the entity. The Final Rules allow the holding company to rebut that presumption, and also create specific exemptions from the presumption if no director, officer, or employee of the holding company serves as a director, GP, or trustee of the entity, or if certain third party stock ownership tests are satisfied.

Funds: The Final Rules also specify that the term "affiliate" includes any unregistered fund for which the bank serves as investment advisor, if the bank or its affiliates control more than 5% of any class of voting securities or of the equity capital of the fund. However, "eligible affiliated mutual fund securities" (i.e., securities of a registered open-end investment company meeting certain requirements) will not be treated as nonaffiliate collateral, unless the bank has reason to know that the proceeds of loan will be used for the benefit of an affiliate. See above for rules on private equity funds.

Special Cases of Affiliates: In addition to the "affiliate" issues with funds and GLB affiliates as described below, the Final Rules create additional "affiliates" for purposes of Section 23A. Any partnership for which the bank, or any affiliate or representative serves as a general partner will be deemed an affiliate. Any subsidiary of a bank which is also "controlled" by another affiliate (other than a bank affiliate) will be deemed an affiliate of the bank. Any ESOP or similar organization will be deemed an affiliate. Finally, any uninsured bank will not be deemed a bank for purposes of the bank-to-bank exemption, and thus any transaction between an insured and uninsured sister company banks (that is not a subsidiary of an insured bank) will be subject to Section 23A.

The Final Rules also define the applicability of Section 23A to certain arrangements which generated significant industry comment when the proposal was issued.

Derivatives: The Final Rules specify that all derivative transactions are subject to Section 23B (including use of daily marks to market and two-way collateralization). As a general matter, the Final Rules do not subject derivatives to Section 23A, but require banks to establish policies to monitor credit exposures to affiliates. However, derivatives in which a bank provides credit protection

to a nonaffiliate on behalf of an affiliate will be treated as a guarantee of the affiliate for purposes of Section 23A. Moreover, in the near future, the FRB will propose regulations to treat derivatives that are the functional equivalent of a loan to an affiliate (i.e., a purchase of a deep-in-the money option from an affiliate) as subject to Section 23A.

Lending Affiliate Exemption: Historically, a bank’s purchase of loans from an affiliate were exempt from Section 23A so long as:

(1) the bank makes an independent evaluation of the credit-worthiness of the borrower, and (2) the bank commits to purchase the loan prior to the affiliate making the loan (the "250.250 Exemption"). The proposal incorporated the Board’s supplemental opinion that the bank’s loan purchases could not represent more than 50% of loans made by the affiliate, and also added a more amorphous requirement that the bank could not provide "substantial, ongoing funding" to the affiliate. In response to strong adverse industry comment, the Final Rules do not include the latter condition of the proposal (but do contain the 50% test). However, the FRB now is seeking public comment on a new proposal that would deny the 250.250 Exemption if loans purchased by the bank from an affiliate represent more than 100% of the bank’s capital.

Credit Cards: Like the proposal, the Final Rules exempt from Section 23A extensions of credit under a "general purpose" credit card even if the borrower uses the proceeds to purchase goods or services from an affiliate. Despite industry comment about burdensome monitoring requirements, the Final Rules retain the proposal’s requirement that for a credit card to be considered "general purpose" less than 25% of the aggregate amount of purchases be from a commercial affiliate of the bank (a grace period would be available for temporary noncompliance). The Final Rules do seek to respond somewhat to industry comment by exempting from the 25% test any bank that does not have nonfinancial affiliates (i.e., only has Section 4 affiliates), as long as the bank has no reason to believe the limit is not satisfied, and any bank that can demonstrate to the FRB that only a minimal percentage of purchases would be from an affiliate. The FRB also notes that banks with credit cards that did not qualify for the general purpose exemption could use the same approach to avoid Section 23A as issuers of special purpose cards – sell their receivables daily or establish earmarked deposit accounts.

Intraday Extension of Credit: The Final Rules declare that, while intraday credits are subject to Section 23B, they will not be subject to Section 23A if (i) the bank adopts policies to manage credit risk arising from intraday credit, and (ii) at the time the bank extends credit, it has no reason to believe the affiliate will have difficulty repaying it. Notably, whereas the proposal only would have exempted certain types of intraday credit, the Final Rules exempts all types of intraday credit.

Bank -Affiliate Merger and Acquisition Transactions: The Final Rules also address how Section 23A will apply to bank mergers with affiliates (and non-affiliates that become affiliates) and contributions of stock of an affiliate to a bank. Of particular note, (with a specified exemption for "step" transactions in which an entity becomes a bank affiliate through acquisition and contemporaneously becomes a bank subsidiary), the Final Rules state 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, as was the historical practice) will be deemed part of a covered transaction, even if there is a net transfer of value to the bank. The ongoing value of the covered transaction may be reduced by sales of assets of the subsidiary, or amortization of the subsidiary’s assets. Moreover, the Board noted that it will continue to grant exemptions from Section 23A for these types of transactions on a case-by-case basis.

US Branches/Agencies of Foreign Banks: To ensure competitive equality between US and foreign banks, the Final Rules 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: non-credit related insurance underwriting, securities underwriting and dealing, merchant banking, and insurance company investment activities. The Section 23A "capital and surplus" would be defined by reference to the capital of the foreign bank.

In its Final 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 rules are likely to increase the likelihood that an unwary institution will be deemed to violate thoseprovisions.