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Appeal of Potential Violation of the Legal Lending Limit (Second Quarter 1999)

Background

The ombudsman received a second tier formal appeal of a violation of 12 USC 84, the Legal Lending Limit.  The supervisory office combined the loans to six individual borrowers under 12 CFR 32.5 (b) ''Direct Benefit'' and 12 CFR 32.5 (c) ''Common Enterprise'' rules.  After the violation was cited in the report of examination (ROE), the bank initially appealed the violation to the Office of the Chief Counsel in Washington, D.C.  The Office of the Chief Counsel opined that a violation of the legal lending limit had occurred; bank management then opted to appeal the cited violation to the ombudsman.

The legal lending limit violation cited in the ROE resulted from the combining of unsecured loans to six individual borrowers.  The loan proceeds were invested in a real estate development limited liability company.  Collectively, these six individuals own 100 percent of the company.  The appeal letter stated the bank was not relying on the real estate development entity for repayment of the debt, hence there was no performance risk associated with the company.  Bank management stated the loans were made to the individuals based on each individual's credit worthiness and capacity to repay the loan.  The appeal letter outlined the following as the basis for the bank's appeal:

  • Only two of the individuals have ''voting rights or voting interest,'' except in certain limited situations, and the limited liability company structure does not require a person to have voting rights in equivalent proportion to their investment.  To the extent that the prior decisions relied upon by the Office of the Chief Counsel were based on corporate structures or more traditional partnership structures where dollars of investment equaled voting power, a different analysis should be applied here and a different conclusion reached.
  • Given the fact that each loan was underwritten based on the individual borrowers' creditworthiness, coupled with the limited exposure of each borrower under the limited liability company structure, the credit diversification goal of 12 USC 84 is met.
  • Under the facts of this situation there is no risk related to undo industry concentration, nor are the technical requirements of ''common enterprise'' met.

Discussion

Generally, a national bank's total outstanding loans to one borrower may not exceed 15 percent of the bank's capital and surplus, plus an additional 10 percent of capital and

surplus if the amount over the 15 percent general limit is fully secured by readily marketable securities.  See 12 USC 84 (a); 12 CFR 32.3 (a).  A ''borrower'' includes a person who is named a borrower or debtor in a loan or extension of credit (see 12 CFR 32.2(a)).  Also, loans or extensions of credit to one borrower will be attributed to another person and each person will be deemed a borrower (1) when the proceeds are used for the direct benefit of the other person, or (2) when a common enterprise is deemed to exist between the persons.  See 12 CFR 32.5 (a).

The proceeds of a loan or an extension of credit to a borrower will be deemed to be used for the direct benefit of another person and will be attributed to the other person

when the proceeds, or assets purchased with the proceeds, are transferred to another person, other than in a bona fide arm's length transaction where the proceeds are used to acquire property, goods, or services (see 12 CFR 32.5 (b)).  A common enterprise will be deemed to exist and loans to separate borrowers will be aggregated when:

  1. 1)     The expected source of repayment for each loan is the same and neither borrower has another source of income from which the loan and the borrower's other obligations can be repaid;
  2. 2)     The borrowers are related through common control and there is substantial financial interdependence between or among the borrowers;
  3. 3)     the borrowers use the loan proceeds to acquire a business enterprise of which those borrowers will own more than 50 percent of the voting securities or voting interests of that enterprise;
  4. 4)     The OCC determines that a common enterprise exists based on the facts and circumstances of a particular transaction.  See 12 CFR 32.5 (c).  Thus in determining whether a loan to one borrower should be attributed to another borrower for lending limit purposes, one must apply each of the five loan combination/attribution tests set forth above-the direct benefit test and the four common enterprise tests-to the specific facts of each loan relationship.

Conclusion

Direct Benefit

In determining the applicability of the ''direct benefit'' test under 12 CFR 32.5(b), the OCC has long considered an equity investment in a company to be a direct benefit to that company, since the equity investment, at a minimum, provides the company with  additional working capital.  In this case the loan proceeds represented the initial working capital for this newly formed business and while this was a bona fide transaction, there was no property, goods, or services acquired from the company.  Given these facts, the ombudsman found the provisions of the 12 CFR 32.5(b) and the precedent letters relied on in citing the violation of 12 USC 84 in the ROE were applicable to this case and appropriately applied.

Common Enterprise

The four tests for common enterprise under 12 CFR 32.5(c) is independent of one another.  That is, all four tests do not have to be met to determine that a common enterprise exists; if one test is met then a common enterprise is deemed to exist.  While in some scenarios, independent sources of repayment prevent combining loans to different borrowers, in this case, the individual financial capacity of the six borrowers was not relevant to the violation cited in the ROE.  The operating agreement, referenced in the appeal, designated two of the six borrowers as managers and empowered them to act extensively in a decision-making capacity.  The agreement also provided all owners of the company with voting authority for certain actions.  The voting privileges specified in the operating agreement were associated with the individuals' percentage of ownership interest in the company, in that an affirmative vote from a certain percentage of the ownership interest was required for passage.  Therefore, it is reasonable to conclude that the borrowers' investment in the company was commensurate with their voting interest.

The appeal did not dispute that the six borrowers used the borrowed funds to acquire the business enterprise and collectively owned 100 percent of the company.  Considering the conclusion reached regarding voting interest of the six owners based on the operating agreement, the ombudsman determined the criteria for ''common enterprise'' under 12 CFR 32.5(c) (3) was applicable to this case.  The combined ownership of the six individuals that borrowed to invest in the company exceeded the 50 percent voting interest threshold in the regulation.  Based on these facts, the ombudsman confirmed that a ''common enterprise'' exists and the precedent letters relied on in that determination was appropriate.  Therefore, the ombudsman did not reverse the citing of the violation of the bank's legal lending limit under 12 USC 84.