I. INTRODUCTION
Section 23A of the Federal Reserve Act regulates the loan or credit amount that can be extended to the “affiliates” of a lending bank. The section applies to all banks which are FDIC insured or Federal Reserve System members.
“Affiliate” is defined generally to include any bank holding company of which the bank is a subsidiary and any other subsidiary of such bank holding company. Loans made to an “affiliate” must not exceed, in the aggregate of 10% of the capital stock and surplus of the bank for any one “affiliate.” The aggregate amount of credit extended by the bank to all of its “affiliates” must not exceed 20% of capital stock and surplus.
All loans or extension of credit are to secured by collateral that has a market value greater than the amount of the loan, unless secured by federal obligations or other collateral which the Federal Reserve Banks accept for rediscount. If collateral is made up of state governmental obligations, then the collateral must be at least 10% greater than the loan. If other than the above collateral is given, the collateral must be at least 20% more than the loan.
The restrictions of Section 23A apply additionally to investment in the obligations of any “affiliate” and also to the use of any “affiliate’s” stock or obligations as collateral for loans or advances to any person.
II. COMPLIANCE NOTES
A. Definitions
The definition of “affiliate” includes certain entities but excludes others. For example, a company “sponsored or advised on a contractual basis by a bank or a subsidiary or affiliate thereof is an “affiliate” as is a company the bank serves as an investment advisor within the confines of the Investment Advisors Act of 1940. Of course, subsidiary banks of the same holding company or part of a chain are within the definition of “affiliate.”
On the other hand, Section 23A excludes specific entities from the “affiliate” definition. A company whose sole business is ownership of the bank premises or a safe deposit box business is not an “affiliate.” A company controlled by the bank through foreclosure is not an “affiliate” so long as control is divested before the state or federal statutory time period runs out.
NOTE: Only companies (i.e., corporations, partnerships, associations, and similar organizations, including banks) are “affiliates” under Sections 23A whereas transactions between a bank and an individual (even if the individual controls the bank) are not covered by Section 23A. This is because transactions with individuals are regulated elsewhere, e.g., Reg. O.
Other types of “affiliates” are defined with reference to the term “control.”
Section 23A provides 3 tests for determining control:
Another important provision of Section 23A states:
"Any transaction by a member bank with any person shall be deemed to be a transaction with an affiliate to the extent that the proceeds of the transaction are used for the benefit of, or transferred to, that “affiliate.”
For example, Big Red bank lends money to Mr. Farmer to buy shares in Farm Supply Company. Mr. Merchants owns 30% of the stock for both Big Red Bank and Farm Supply Company. Would the loan to Mr. Farmer trigger Section 23A? Yes. For the purposes of Section 23A, Farm Supply Company is deemed an “affiliate” of the bank, and although the money was advanced to Mr. Farmer, the loan proceeds are “used for the benefit of, or transferred to” Farm Supply Company. The loan would be unlawful if it exceeded Section 23A lending limitations and restrictions.
The term “capital stock and surplus” as used in Section 23A is also a key definition. Capital and surplus, under Section 23A conforms to the definition of unimpaired capital and unimpaired surplus used by the Federal Reserve Board in calculating the limits in Regulation O for insider lending and by the OCC in calculating the limit on loans by a national bank to a single borrower. The term includes Tier 1 and Tier 2 capital, as calculated under the risk-based capital guidelines, plus the balance of the allowance for loan and lease losses (ALLL) not ordinarily counted in Tier 2 capital. Under the banking agencies’ risk-based capital guidelines, Tier 1 capital includes common equity, some noncumulative perpetual preferred stock and related surplus, and minority interest in equity accounts of consolidated subsidiaries. Tier 2 capital includes the ALLL up to 1.25% of the bank’s weighted risk assets, perpetual preferred stock and related surplus, hybrid capital instruments, and certain types of subordinated debt.
The definition permits a bank to include in capital the bank’s subordinated debt that qualifies for inclusion in Tier 2 capital, but Tier 1 capital does not include securities revaluation reserves, in particular, gains and losses on available-for-sale securities, which under Statement of Financial Accounting Standards number 115 (FAS 115) are considered a component of equity capital. Tier 1 capital also excludes certain intangible assets, most notably goodwill.
B. Limitations/Restrictions
Section 23A limitations and restrictions apply to “covered transactions:”
Covered transactions are not prohibited, but are regulated as to loan amount and collateral taken with regard to transactions with “affiliates.” Exemptions are also provided for specified transactions.
As stated in the Introduction to this article, a bank’s aggregate transactions with an “affiliate” cannot exceed 10% of the bank’s capital and surplus and the aggregate transactions with all “affiliates” cannot exceed 20% of the bank’s capital and surplus. All loans, guarantees, letters of credit and acceptances are subject to minimum collateral requirements (from 100% if collateral is in U.S. obligations to 130% if collateral is real estate or stock). A bank cannot engage in a transaction with an “affiliate” where stock of the “affiliate” or any other “affiliate” of the bank is taken as collateral. An “affiliate” stock may be accepted as collateral for transactions involving a “nonaffiliate,” but such a transaction then becomes a “covered transaction.” This means that although the transaction is permitted, it is subject to amount limitations (10% or 20% of capital and surplus).
“Low-quality assets” (loss, doubtful, substandard, special mention, on a non accrual basis, 30 days past due on principal or interest, compromised or renegotiated because of weakness in debtor’s financial condition) are ineligible as collateral for a transaction with an “affiliate.” Section 23A expressly prohibits the bank or its subsidiaries from purchasing a low-quality asset from an “affiliate,” except where commitment to purchase the asset (based on an independent credit evaluation) before the “affiliate” acquired the low-quality asset.
As stated above, certain transactions are exempted from loan limits and collateral restrictions (except in cases involving safety and soundness or the restriction against low-quality assets):
III. NEBRASKA DEPARTMENT OF BANKING
The Nebraska State Department of Banking and Finance has issued a Statement of Policy in regard to Federal Reserve Act Section 23A. Statement of Policy No. 12 (effective May 23, 1984, and revised May 22, 1986, and March 31, 2016) states the following:
A state-chartered bank is prohibited from purchasing a loan subject to adverse classification by federal or state regulatory agencies unless a clear and definitive program is developed to provide for the orderly liquidation of the entire line of credit files of the borrower. Section 23A of the Federal Reserve Act prohibits the purchase of a credit subject to adverse classification by regulatory agencies from an affiliated bank, and allows for renewal of those credits on the books of the purchasing bank at the time of classification only under certain conditions. The current Department policy permits the renewal of such loans in non-affiliated banks. However, due to the Department’s continuing concern about economic conditions and the placement of overlines, the policy permits renewals of adversely classified overline loans in non-affiliated banks only if the customer’s credit file contains a written program providing for the orderly liquidation of the entire line of credit.
When a loan is participated because it is over the bank’s legal lending limit, a state-chartered bank may not place the participation with recourse or otherwise agree to buy back the notes if the borrower defaults or otherwise does not make payment. State-chartered banks should be cautious that they do not make any representations that they will be liable for such placed paper.
IV. CONCLUSION
Compliance is an especially high priority should your bank deal with “affiliates.” A banker who participates in a violation of Section 23A may be subject to a civil penalty of up to $1,000 for each day the violation continues. This article is intended to provide a basic understanding, and not an exhaustive discussion of a very complex law and should acquaint bankers with major issues or transactions that may trigger the law.