This is Part Two of our two part article on common insider lending problems that we have identified in the industry.  (Read Part One here.) This installment focuses on the appropriate treatment and handling of lines of credit to insiders.

There are a number of types of line of credit, and the type can make a significant difference to the Regulation O requirements. “Extensions of credit” to insiders are subject to Regulation O and therefore are subject to dollar limits, board approval for larger loans, arms’ length requirements and, if made to executive officers, additional limitations. However, two types of line of credit are not “extensions of credit” for Regulation O purposes and therefore are not subject to these limitations. Lines of credit that are not extensions of credit are:

a) Open-end credit plans of $15,000 or less so long as:

(i) The debt does not involve prior individual approval by the bank other than for the purposes of determining authority to participate in the arrangement and compliance with any dollar limit under the line; and

(ii) The terms are not more favorable than those offered to the general public.

b) Indebtedness of $5,000 or less arising by reason of an interest-bearing overdraft credit plan of the type specified in 12 C.F.R. § 215.4(e), which requires a written, preauthorized, interest-bearing extension of credit plan that specifies a method of repayment.

There are limitations to these lines of credit, per regulatory opinion, that are not particularly obvious but which must be complied with in order for these lines to satisfy the exclusion from the definition of extension of credit.

1. Only Certain Dollar Limits Apply. These lines are not subject to the dollar limitations of 12 C.F.R. § 215.4 or, for executive officers, 12 C.F.R. § 215.5, but they are subject to the dollar limitations stated in the exclusion itself: $15,000 for a general line of credit and $5,000 for an overdraft line of credit.

2. If Accessible through Overdrafts, the Credit is subject to the Limits for Overdraft Lines of Credit. If a line of credit can be accessed when the customer overdraws his or her deposit account, then it is by definition an overdraft line of credit and must satisfy the $5,000 limit. FRB Interp. Letter, Dec. 6, 1996. Likewise, such a line of credit must satisfy the other requirements of 12 C.F.R. § 215.4(e), and in particular that it be represented by a written, preauthorized, interest-bearing extension of credit plan that specifies a repayment method.

However, these two conditions apply only if the bank wants the line of credit to qualify for the exception from the definition of “extension of credit.” So long as the bank is willing to handle the line of credit like any other extension of credit to an insider, including without limitation with respect to board approval and re-approval requirements (re-approval requirements are discussed below), the $5,000 or $15,000 limits would not apply. The lines would instead be subject to the other amount limitations of Regulation O.

3. The $15,000 Line Must Have Standard Collateral. The $15,000 line of credit must not be secured by collateral of the kind not ordinarily used by the bank for such lines. FRB Interp. Letter, Dec. 6, 1996. Regulatory opinions are not clear on this issue, but it seems that the bank should be able to offer home equity lines of credit under this exception, secured by the borrower’s home, if the credit limit is $15,000 or less and the bank otherwise offers similar home equity lines to borrowers.

All lines of credit other than the two types described above (and certain credit card or check credit plans not discussed here) are fully subject to Regulation O, including all board approval requirements, dollar limitations, and the executive officer restrictions.

In general, all lines of credit to insiders, other than the $15,000 lines and the $5,000 overdraft lines discussed above, must be re-approved by the bank’s board at least every 14 months. However, if the line of credit has dollar limits such that board approval was not required when the line was made, then this 14-month re-approval requirement also should not apply. The difficulty could be in applying this exclusion in practice.

Board approval of an insider loan is technically required only if the loan, together with all other loans to that insider and his or her related interests, exceeds $500,000 or the higher of $25,000 or 5% of the bank’s unimpaired capital and unimpaired surplus. Thus, if the line of credit is below these limits and the bank has no other loans to the insider or related interests, then the line should not require board approval and likewise should not require re-approval under the 14-month rule.

Of course the difficulty is that many or most insiders that borrow from the bank will have loans in addition to the line of credit. Moreover, an insider who first gets a line of credit that does not require board approval might later obtain additional loans, with the result such that the borrower’s total debt then exceeds the dollar thresholds at which board approval is required.

This leaves a bank two options when determining its Regulation O policies and procedures: (1) always require board re-approval of lines of credit within 14 months or (2) require the Chief Credit Officer to determine prior to the 14-month deadline if the insider and his or her related interests have loans (including the line of credit) that in the aggregate exceed the 5%/$25,000/$500,000 limits and then to obtain board approval for renewal of the line only if the loans exceed these limits. Even with this approach, however, the line of credit agreement will need to require re-approval by the bank every 14 months to ensure that the bank can refuse to renew the line in appropriate circumstances.