The Basic Requirements and Restrictions of Transactions with Bank Affiliates
Section 23A and 23B of the Federal Reserve Act restrict a wide range of transactions between a bank and its affiliates. The affiliate transaction requirements under Sections 23A and 23B have three related central purposes: (1) to prevent affiliates from taking advantage of a bank through transactions having non-market terms; (2) to prevent the transfer of the benefits of the bank safety net (i.e., FDIC insurance and access to the Federal Reserve Bank discount window) to non-bank affiliates; and (3) to ensure the safety and soundness of the bank.
Section 23A general imposes restrictions on certain types of so-called “covered transactions” between a bank and its affiliates, including quantitative limits, collateral requirements, and other prudential limitations (consistent with safe and sound banking practices). Section 23B complements Section 23A by requiring that covered and a broader range of other types of transactions involving a bank and an affiliate be conducted on terms and under conditions that are at least as favorable to the bank as prevailing market terms. In addition to Section 23A and 23B, Section 11 of the Home Owners’ Loan Act (HOLA) imposes certain additional affiliate transactions prohibitions on savings associations. The Federal Reserve Board (Federal Reserve) has issued Regulation W to implement the requirements of Sections 23A and 23B, as well as Section 11 of HOLA. However, Regulation W does not yet reflect amendments to Sections 23A and 23B that were made in the Dodd-Frank Act of 2010.
Whether or not Sections 23A or 23B, and in the case of savings associations Section 11 of HOLA, and Regulation W apply to a particular bank transaction depends, first, on whether the transaction is with or relates to an affiliate of the bank, and second, the type of transaction involved.
The most common types of affiliates under Sections 23A and 23B, Section 11 of HOLA and Regulation W include the following:
Parent company. Any company that controls the bank;
Company under common control by a parent company. Any company that is controlled by a company that controls the bank;
Sponsored and advised companies. Any company that is sponsored and advised by the bank or an affiliate of the bank; and
Investment companies. Any investment company where the bank or any affiliate of the bank serves as an investment advisor (as defined in Section 2(a)(20) of the Investment Company Act of 1940, as amended (15 U.S.C. 80a-2(a)(20))
Banking and financial subsidiaries of banks. While generally subsidiaries of banks are not treated as affiliates for purposes of Sections 23A and 23B and Regulation W, there are two exceptions to this rule: a subsidiary of the banks that is also a bank or is a so-called “financial subsidiary” of the bank.
The types of transactions to which the provisions of Section 23A apply are called “covered transactions” and include, among other things, the following:
Any loan or extension of credit by the bank to an affiliate;
Issuance of a guarantee or letter of credit on behalf of an affiliate;
A purchase of assets, including assets subject to a repurchase agreement, from an affiliate; and
Holding affiliate securities, either as a result of a purchase of securities issued by an affiliate or the acceptance of securities or best obligations issued by an affiliate as collateral for an extension of credit to a third party.
The transactions that are subject to the market terms requirements in Section 23B include not only covered transactions but also the following additional transactions:
The sale of a security or other asset by a bank to an affiliate; including sales subject to an agreement to repurchase;
The payment of money or the furnishing of a service to an affiliate;
Any transaction in which an affiliate acts as Ann agent or broker or receives a fee for its services to the bank or to any other person; and
Any transaction with a nonaffiliated (i) if an affiliate has a financial interest in the third party, or (ii) if an affiliate is a participant in such transaction.
Section 23A and Regulation W impose several important restrictions on covered transactions between banks and their affiliates, including:
Quantitative limitations on covered transactions;
Collateral requires that apply to credit transactions;
A prohibition on banks purchasing low-quality assets; and
A general safety and soundness requirement.
Section 23A/Regulation W quantitative limitations on covered transaction consist of the following:
All covered transactions between a bank and one affiliate may not exceed 10% of the bank’s capital and surplus; and all covered transactions between a banks and all of its affiliates may not exceed 20% of the bank’s capital and surplus.
Affiliate transactions that are subject to collateraliation requirements include the following:
An extension of credit by a bank to an affiliate;
The issuance of a letter of credit guarantee by a bank on behalf of an affiliate; and
Any credit exposure of a member bank or a subsidiary to an affiliate resulting from a securities borrowing or lending transaction, or a derivative transaction.
The amount of collateral that must be posted depends on the type of collateral used to secure the transaction and ranges from 100% to 130% of the amount of the credit transaction depending on the type of collateral that is pledged.
Section 23A also places restrictions on the collateral that may be used to secure credit transactions. Ineligible collateral includes the following:
Generally, securities and debt obligations issued by an affiliate;
Low-quality assets;
Securities issued by the bank that are included in its regulatory capital;
Intangible assets (including servicing rights); and
Guarantees, letters of credit, and other similar instruments.
Section 23A and Regulation W prohibit a bank from purchasing low-quality assets from an affiliate. A low-quality asset means any of the following: (1) classified or special mention assets, including most non-investment grade securities; (2) loans in non accrual status; (3) loans on which principal or interest is more than 30 days past due; or (troubled debt restructurings.
Section 23A/Regulation W also prohibit banks from engaging in any covered transaction, including those exempt under Regulation W, unless the transaction is conducted on terms and conditions that are consistent with safe and sound banking practices.
Section 23A/Regulation W exempt various covered transactions from the quantitative limits and collaterization requirements in Section 23A, but the exempt transactions must still satisfy the market terms requirements of Section 23B. Some exemptions include:
Credit transactions with an affiliate that are fully secured by either obligations of the United States or its agencies, obligations guaranteed by the United Sates or its agencies as to principal and interest, or a segregated, earmarked deposit account with the bank;
The so-called “sister bank” exemption involving a transaction with an affiliated bank if the same company controls 80% of more of the voting securities of both banks; (These transactions are still subject to the prohibition on purchasing low-quality assets.)
Purchasing an asset from a securities affiliate at a readily identifiable and publicly available market quotation;
Purchasing a security from a securities affiliate that is eligible for purchase by a bank and has a “ready market” if certain additional conditions are satisfied; and
A purchase of securities from a securities affiliate acting exclusively as a diskless principal if the security is not issued, underwritten or sold by an affiliate.
Section 23B/Regulation W complement the protections provided by Section 23A by also requiring that covered transactions and certain additional transactions between a bank and an affiliate be conducted on market terms and be subject to certain other limitations and requirements. The primary Section 23B/Regulation W limitations and requirements are:
A market terms requirement;
Fiduciary restrictions;
Securities purchase limitations when an affiliate is acting as a principal underwriter; and
A prohibition on assuming responsibility for affiliate obligations.
All transactions subject to Section 23B and the relevant Regulation W implementing provisions must be conducted on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to the bank, as those prevailing at the time for comparable transactions with or involving third parties. In the absence of comparable transactions, the transaction must be conducted on terms and under circumstances, including credit standards, that the bank in good faith would offer to third parties. Under this standard, it is important to note that a transaction that is more favorable to the bank than if the bank engaged in the transactions with a nonaffiliated on market terms would not violate this market terms requirement.
Section 23B/Regulation W would prohibit a bank acting as a fiduciary from purchasing any security or other asset from any affiliate unless the purchase is permitted either (1) under the instrument creating the fiduciary relationship, (2) by court order, or (3) by the law governing the fiduciary relationship.
Section 23B/Regulation W also place limitations on a bank’s ability to purchase securities when an affiliate is acting as a principal underwriter of the security. Specifically, a bank, acting either as principal or fiduciary, may not purchase any security if a principal underwriter of that security is an affiliate of the bank.
Finally, Section 23B/Regulation W prohibit a bank and its affiliates from publishing or advertising that the bank is responsible for the obligations of an affiliate.