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Appeal of Violation of Insider Lending Limitations (First Quarter 1996)

A bank appealed a violation of insider lending limitations cited in the most recent examination report. The violation involved overdrafts on the personal checking account of the bank's chairman of the board (COB). The COB overdrew his account at the bank 21 times over a 161-day period during 1995. The overdrafts were less than $1,000 in amount, less than five days in duration, and subject to appropriate charges. However, the supervisory office concluded that the frequency and dollar amounts involved indicate that the overdrafts should not be considered inadvertent. The examination report also cited several other insider violations that the bank did not appeal. OCC notified the bank that it is strongly considering civil money penalties (CMPs) against the COB and other individuals who approved loans causing violations or failed to prohibit the COB's overdrafts. The supervisory office notes that the bank has experienced chronic insider loan problems, often involving the COB, since he acquired the bank in 1989. These problems include previous illegal overdrafts in 1992 and 1993. In 1993, the OCC issued a letter of reprimand to the COB and supervisory letters to other insiders addressing the bank's insider lending practices. The bank's board of directors adopted a policy that disallowed the payment of any overdrafts on the accounts of officers and directors.


The regulation dealing with overdrafts of an executive officer is 12 CFR 215.4(e). It prohibits member banks from paying an overdraft of an executive officer or director except in accordance with a written, preauthorized, interest-bearing extension-of-credit plan. There is also an exception for a written, preauthorized transfer of funds from another account of the account holder at the bank. This prohibition does not apply to inadvertent overdrafts on an account in an aggregate amount of $1,000 or less, provided that the account is not overdrawn for more than five business days, and the member bank charges the executive officer or director the same fee charged any other customer of the bank in similar circumstances.

Counsel for the bank argues that the above-stated provision should be interpreted to mean that an overdraft is inadvertent if it is less than $1,000, remains for no more than five days, and is charged the same fee charged any other customer. In other words, the provision should be read as though the word "inadvertent" was unnecessary or omitted. The appeal maintains that the OCC's determination is based upon subjective criteria not included in the regulation. As such, it is inherently unfair and arbitrary because the OCC's apparent maximum number of permissible overdrafts has not been disclosed to anyone in advance. Thus, it is not possible to anticipate or predict OCC's conclusions.

OCC and Federal Reserve Board precedents provide no support for counsel's position. In 1989, the OCC ruled that "[a]n overdraft that is not made in accordance with a written, preauthorized payment plan is permissible under 12 CFR 215.4(d) only if it is inadvertent, in an amount of less than $1,000, does not exceed five business days, and the bank charges the executive officer or directors the same fee charged to other customers" (emphasis added). Decision of the Comptroller of the Currency No. AA-EC-87-123, January 12, 1989. In this decision, the Comptroller saw "inadvertence" as a requirement of the provision.

The COB states that an employee maintains his checking account for him. He was unaware of the 1995 overdrafts until after the fact. When notified of the overdraft activity, the COB was certain the bank was in error. Upon analysis, he was surprised to find that the bank statements were accurate. Therefore, he believes the overdrafts were inadvertent. However, the OCC had notified the bank in a 1993 letter from the supervisory office that, in part, because a pattern was present, the overdrafts could not be considered inadvertent - regardless of the amount or duration. In addition, the letter of reprimand to the COB stated that he had caused overdrafts to occur in his accounts and his related interests accounts. The letter reminded him of his fiduciary obligations to the bank. The reprimand concluded by stating that OCC would consider its issuance to be a formal prior supervisory warning should he be involved in future violations, unsafe and unsound practices, or breaches of his fiduciary duty. Further, several members of management and the board received training and information about insider loan limitations in the month just prior to the approval of the 1995 illegal insider transactions.


The Ombudsman decided that the overdrafts are not inadvertent. He decided that the overdrafts are not inadvertent. He believes that the provisions in the regulation (i.e., less than $1,000, no more than five days, and charged the same fee as any other customer) are separate and distinct conditions from the term "inadvertent." The inclusion of the word in the regulation provides a fourth condition necessary to exempt certain overdrafts from the prohibition cited in the regulation. He based this appeal decision on the language of the regulation, OCC legal precedent, and the extent of the COB's overdraft activity.

The COB has repeatedly been in the position of over-drafting his checking account an inordinate number of times. His experience with overdrafts in 1992 and 1993, the bank's policy prohibiting overdrafts on accounts of officers and directors and the letter of reprimand from the OCC, raised the issue to a level of consciousness that eliminates the possibility of inadvertence in 1995. Bank insiders have positions of responsibility and leadership in the community. As such, they must avoid even the appearance of transactions that are, or could become, abusive. Although the impact of such transactions may seem small, they are symptomatic of a lax approach to the responsibility insiders owe the bank and its depositors. The ombudsman appreciates the COB's surprise upon learning of the overdrafts. However, delegating the management of his personal account does not excuse the COB of his responsibility to ensure that it is handled in a legal and responsible manner. The cited violation in the examination report will remain.

Appeal of Violation (First Quarter 1996)

A bank appealed to the ombudsman a violation of 12 CFR 9.12 (a) cited in its 1993 report of examination (ROE.) In response to the Roe, the bank first sought relief from the supervisory office by making a request for an interpretive ruling. The supervisory office, through district counsel, upheld the examination results in that first-tier appeal. In 1995, the bank made a formal second-tier appeal to the ombudsman that requested a review of the conflict of interest issues in its method of utilizing the services of its third-party provider of discount brokerage services for the settlement of the fiduciary security transactions.


The bank wanted to continue to use its unaffiliated third-party provider to transact discount brokerage services for the bank's trust department. The contractual agreement allowed trades only for nondiscretionary trust accounts and bank accounts. No trading in discretionary trust accounts was permitted under the agreement. Under the terms of this agreement, the bank received 50 percent of the brokerage commissions.

The bank also shared in brokerage commissions that were charged discretionary trust accounts by the unaffiliated third-party broker for services the broker rendered to those trust accounts. These trades are not governed by the bank's contract with the third-party broker. However under the bank's commission arrangement with the discount brokerage, the bank received a flat fee for each discretionary trust transaction. The bank provided information that indicated that it did not "profit" from this type of trust transaction but that the fee represented only a partial recovery of the bank's cost to process a trade. The bank also provided a comparison of other brokerage commission alternatives that indicated that its provider was cost effective. Lastly, the bank's contract with its brokerage provider did not contain any activity-based escalator clauses.


Regulation 12 CFR 9.12 (a) states:

Unless lawfully authorized by the instrument creating the relationship, or by court order or by local law, funds held by a national bank as fiduciary shall not be invested in stock or obligations of, or property acquired from, the bank or its directors, officers, or employees or individuals with whom there exists such a connection, or organization in which there exists such an interest, as might affect the exercise of the best judgment of the bank in acquiring the property, or in stock or obligation of, or property acquired from affiliates of the bank or their directors, officers or employees.

The OCC enacted 12 CFR 9.12 (a) to codify for nationally chartered banks the pervasive state common law principle that trustees owe their trust beneficiaries a duty of loyalty. The duty of loyalty is a basic, underlying tenet of the common law of trust. A trustee's duty of loyalty requires the trustee to avoid transactions that, as the regulation states, "might" cause the trustee to disregard or ignore the trust beneficiaries' interests.

OCC Fiduciary Precedent 9.3905 identifies the existence of a conflict of interest when a bank uses a brokerage service to execute trades for the bank's trust accounts when the bank also receives "a share of the commissions or other consideration"; a flat transaction fee should certainly qualify as "other consideration." Fiduciary Precedent 9.3905 further states that:

A brokerage service may be used for fiduciary accounts if the bank receives no compensation from the broker and fiduciary accounts receive best execution. If the bank receives compensation in any form, then the trust customers must provide specific written authorization to use the brokerage firm after being provided with full disclosure of the arrangement.

Thus, the bank has violated 12 CFR 9.12 (a) through its use of the third-party broker to effect trades for the bank's discretionary fiduciary accounts, but not because the third-party broker is somehow "affiliated" with the bank. It is the bank's receipt of a flat fee from the third-party broker for each fiduciary account transaction that causes the transactions to be in violation of section 9.12 (a). Key to this discussion is the fact that the bank already charges a trustee fee to cover just such expenses. The bank's brokerage agreement with the third-party broker alone would not make the broker a bank "related," "affiliated or "in-house" brokerage service as the ROE implied.

The OCC has previously reviewed conflicts of interest where an unaffiliated broker in a contractual relationship with a bank executes trades for trust accounts, even when no fee is imposed. The contractual relationships are similar in this situation; however, the appealing bank received a flat fee. Notwithstanding the absence of any fee to the bank for trust account trades, the OCC previously concluded that there is a potential for indirect benefit to the bank under such an arrangement. The Bank's contractual arrangement with the third-party broker might affect the trust department's ability to make brokerage choices that are based exclusively on the best interest of its trust customers, even if the bank received no portion of the commission from the trust account trades. The size of the bank's contractual share of the broker's commissions form the non-trust account trades might have been, or may continue to be influenced by the broker's ability to generate revenues from the trust department. Also, the existence of the contractual relationship between the bank and the broker might be dependent on the broker receiving revenues from trust accounts. The bank may be placed in a position where its judgment concerning which broker to use for trust account trades may be unduly influenced by the desire to maintain the contractual relationship with the third-party broker. The absence of volume-related commission scheme does not preclude the potential for indirect benefit to the bank.


The ombudsman decided that the bank's retention of the brokerage fee from the third-party provider does constitute a violation of 12 CFR 9.12 (a). To avoid a violation, the bank must meet one of the exceptions explicitly stated in section 9.12 (a) or obtain the informed consent of its trust customers.

The ombudsman also provided an alternative solution for the bank to avoid a violation of section 9.12. The bank could give each fiduciary account the flat fees it collected from the trades made for that account. In this manner, the bank would not be receiving any compensation form the third-party broker for placing the bank's discretionary accounts' trades. This potential solution will only be appropriate as long as the bank makes certain representations and adheres to them. These representations include:

  • The bank is crediting whatever benefits it is receiving form the third-party broker to its trust accounts. In the appeal letter, the bank represented that the only benefit the bank receives form the third-party broker for the discretionary trust trades was a flat fee per trade. Therefore, if the bank gives these fees to the trust account whose trades generated the fees for the bank and the bank seeks best execution for its trust account trades, then the potential conflict of interest is so minimal that the OCC would permit this activity. However, if the bank begins receiving additional benefits, either directly or indirectly from these trades, and then the OCC would have to review the situation in light of the additional benefits and the potential conflicts they represent.
  • The bank must continue to seek best execution on all its discretionary trust account trades. While the bank represented that the third party broker currently offers the least expensive brokerage service, if this situation changes and a different brokerage service offers better rates, then the bank would have a duty to seek best execution with the other brokerage service-assuming that there are no other considerations that would keep the bank from using that brokerage service.

Appeal of Violations(First Quarter 1996)


A national bank was cited for violations of 12 CFR 226.18 (b) Truth in Lending—Amount Financed, 12 CFR 226.18 (d) Truth in Lending—Finance Charges and 12 CFR 226.18 (e) Truth in Lending - Annual Percentage Rates in its Report of Examination (ROE). The Truth in Lending disclosures for interim construction loans did not accurately reflect the amount financed, finance charges, or annual percentage rates. The bank was informed that these violations required reimbursement under 15 USC 1607 (e) (1) Truth in Lending Simplifications and Reform Act and was provided the policy guide agreed to by the five federal financial regulatory agencies which summarizes the reimbursement provisions of the act. The bank made a formal appeal to the ombudsman to determine 1) if the violations of regulation Z actually occurred, and 2) if the bank had any discretion in calculating the reimbursement amounts.


The bank offers only interim construction financing loans. Other financial institutions provide the permanent financing. While 12 CFR 226.17 (c) Basis of disclosure and use of estimates deals with interim construction loans, Appendix D of Regulation Z addresses the proper disclosure of multiple advance construction loans. Since the bank does not provide the permanent financing for its construction loans, Part I of Appendix D must be used to estimate the interest portion of the finance charge and the APR to make disclosures. Part I states:

Part I - Construction Period Disclosed Separately

  1. If interest is payable only on the amount actually advanced for the time it is outstanding:
    1. Estimated interest—Assume that one half of the commitment amount is outstanding at the contract interest rate for the entire construction period.
    2. Estimated annual percentage rate—Assume a single payment loan that matures at the end of the construction period. The finance charge is the sum of the estimated interest and any prepaid finance charge. The amount financed for computation purposes is determined by subtracting any prepaid finance charge from one-half of the commitment amount.
    3. Repayment schedule—the number and amounts of any interest payments may be omitted in disclosing the payment schedule under 12 CFR 226.18 (g). The fact that interest payments are required and the timing of such payments shall be disclosed.
    4. Amount financed—the amount financed for disclosure purposes is the entire commitment amount less any prepaid finance charges.

On all of the interim construction loans the bank's estimated interest was calculated by multiplying the contract interest rate times the total commitment times the number of days of the commitment divided by 365. This led to an overstatement of the interest portion of the finance charge. The bank disclosed the contract interest rate as the annual percentage rate (APR), which resulted in an understatement of the APR. The bank did not add the origination fee (a prepaid finance charge) to the estimated interest when disclosing the finance charge and no repayment scheduled was disclosed. The bank disclosed the amount financed as the total commitment when the prepaid finance charge (in the form of an origination fee) should have been subtracted from the commitment amount.


The appeal argued that while the Regulation Z disclosures had not been accurate, the customers were fully aware of the cost of obtaining the interim construction loans. Although the origination fees were disclosed (but not included in the calculation of the APR or subtracted from the amount financed), the inaccurate calculations constitute Regulation Z violations; therefore, reimbursement of the affected accounts will be necessary.

The appeal requested the ability to figure reimbursement on the actual annual percentage rate (APR) versus the disclosed APR. Using the OCC's RE Construction Loan APR Software program, reimbursement is figured on the proper disclosure versus the actual disclosure. The Examiner's Guide to Consumer Compliance includes a question and answer section. Based on question number 10 after the Truth in Lending Act section, the bank is allowed an option in figuring reimbursement on multiple-advance loans. It states:

10. How will disclosures containing information properly estimated under 12 CFR 226.5 (C), 12 CFR 226.17 (c), and Appendix D be treated for reimbursement determinations and computations?

Answer: If APR or finance charge is in error for any reason other than properly made estimate, the determination of whether the error constitutes a reimbursable overcharge will be made using the estimated information as disclosed. At the creditor's option, reimbursement will be based on either:

The actual amount of loan advances, with consideration given to the amount and the dates payments were actually made by the borrower, or;

The disclosed amounts or time intervals between advances and between payments.

The basis selected shall be applied, using the lump sum or lump sum/payment reduction method (at the creditor's discretion), to all loans of the same type subject to reimbursement.