On June 28, 2010, conferees from the U.S. House and the U.S. Senate approved the financial regulatory reform conference report (known as the “Dodd-Frank Wall Street Reform and Consumer Protection Act”), and on June 30, 2010, the U.S. House approved a bill that is almost identical to the conference report, except for a change in the so-called “pay-for” amendment (as discussed here). The U.S. Senate will continue its consideration of the legislation following its July District Work Period. Included among its many provisions are amendments to current law governing affiliate transactions between a financial institution and a related party and changes to the legal lending limit for national and state banks. In general, the amendments found in Title VI only broaden the existing restrictions on affiliate and insider transactions to include financial products such as derivatives, repurchase agreements (“repos”) and securities purchase or sale transactions that involve a credit exposure, rather than re-writing the general standards governing affiliate and insider transactions.

Affiliate Transactions under Sections 23A and 23B of the Federal Reserve Act

Under federal law, transactions between a holding company, a bank, its subsidiaries, or its affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. Section 23A imposes collateral reserve requirements on transactions between a bank and an affiliate of the bank that vary based on the credit exposure undertaken by the bank and limits the volume of affiliate transactions permitted by a bank to a percentage of the bank’s capital stock and surplus. In addition, Section 23B requires that affiliate transactions of this sort be made on the basis of market rates and market terms that would otherwise apply if the transaction was at arms-length with a non-affiliated party.

Under current law, “covered transactions” under 23A include (i) a “loan or extension of credit” to an affiliate; (ii) “a purchase of or an investment in securities issued” by an affiliate; (iii) asset purchases, including repurchase agreements; (iv) an “acceptance of securities issued by the affiliate as collateral or security for a loan” extended to any person or company; or (v) the issuance of a guarantee or letter of credit for or on behalf of an affiliate. Sections 608 and 609 of the conference report broaden the category of “covered transactions” under 23A to include derivative transactions, the borrowing or lending of securities, including debt obligations, and expanded categories of repurchase agreements (“repos”). In total, the broadened definition of “covered transactions” now includes almost any transaction in which a bank would experience credit exposure relating to a transaction by or with its affiliate.

In addition, Section 23B currently grants the Federal Reserve the authority to write regulations that exempt subsidiaries of bank holding companies from the affiliate transaction rules of Sections 23A and 23B. Section 608 of the conference report deletes this permissive authority, essentially requiring the Federal Reserve to treat subsidiaries and their bank holding company parents as affiliates subject to the transactional limitations of Sections 23A and 23B. Section 609 of the conference report further broadens the applicability of 23A and 23B to otherwise covered transactions between a bank and its financial subsidiary that are currently exempted under current law.

Finally, Section 615 of the conference report extends similar valuation restrictions to those in Section 23B on transactions between any insured financial institution and one of its executive officers, directors or principal shareholders. Just as Section 23B requires transactions with affiliates to be on market terms, Section 615 requires that a sale of assets by or from an insider must also be on market terms. In addition, should the transaction constitute more than 10% of the financial institution’s capital stock and surplus, a majority of the uninterested directors of the bank or company must pre-approve the transaction.

Legal Lending Limit Extended to Other Forms of Credit Instruments

Currently, under the National Bank Act, national banks are subject to a legal lending limit, in which total loans and credit exposures to a single borrower at one time undertaken by the bank cannot exceed more than 10% of the bank’s total unimpaired capital provided the loan is fully secured. This section (12 U.S.C. § 84) further defines “loans and extensions of credit” to include

all direct or indirect advances of funds to a person made on the basis of any obligation of that person to repay the funds or repayable from specific property pledged by or on behalf of the person and, to the extent specified by the Comptroller of the Currency, such term shall also include any liability of a national banking association to advance funds to or on behalf of a person pursuant to a contractual commitment…

As was the case with affiliate transactions, Section 610 of the conference report broadens the definition of loans and extensions of credit to include credit exposure created by repos and derivative transactions, which are defined as “a contract, agreement, swap, warrant, note or option that is based, in whole or in part, on the value of any interest in, or any quantitative measure or the occurrence of any event relating to, one or more commodities, securities, currencies, interest or other rates, indices or other assets.” Section 614 of the conference report similarly broadens the current law restrictions on loans to directors, officers and principal shareholders of a bank to also include repos, securities lending transactions and derivative transactions.

Section 611 of the conference report effectively extends similar legal lending limit restrictions to derivative transactions for state banks. The conference report permits state banks to engage in derivative transactions, but only if the relevant state lending limit statute considers credit exposure from derivative transactions.

In total, the conference report’s amendments to Sections 23A and 23B of the Federal Reserve Act, as well as its effects on the legal lending limit, can be viewed primarily as a part of the broader regulatory reform of derivative transactions and other previously unregulated financial instruments, rather than as a “game-changer” for bank holding companies and their affiliates. Primarily, the focus of the conference report is to include these previously unregulated financial instruments and their appurtenant credit risk under the existing federal restrictions that have the effect of limiting the credit exposure of financial institutions to a particular borrower or affiliate. With the focus of the amendments largely on including relatively complex financial instruments that are largely the province of Wall Street banks, we believe that the effect of these amendments on community and regional financial institutions should be relatively low.