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REGULATION O - WHAT CONSTITUTES A "NOMINEE" OR "STRAW-PARTY" LOAN?
BY STEPHENS B. WOODROUGH

Introductory Note: The author served as counsel to Glen Garrett from 1994 until 1999 when a civil money penalty action instituted by the FDIC was settled with the issuance of an agency order that withdrew and dismissed, with prejudice, all charges and allegations of wrongdoing. See In the Matter of Glen Garrett, FDIC Enf. Dec. ¶11,599 (1999). The dismissal order was issued prior to the conclusion of the hearing and only required Mr. Garrett to comply with a regulation that he had never violated or even charged with having violated by the FDIC. The discussion in this article is based upon research conducted in preparation for the litigated proceeding with the FDIC.

The most significant adjudicated FDIC enforcement decision involving "nominee" loans is In the Matter of Raymon M. Candelaria, FDIC Enf. Dec. ¶5242 (1997). The final agency decision in Candelaria announced that the FDIC has a "significant history" of removing officers and directors for "making loans to individuals who are nominee borrowers" and using the proceeds of such loans for their own benefit, citing the following cases to demonstrate such history: In the Matter of Veil David DeVillier, FDIC Enf. Dec. ¶10,689 (1992); In the Matter of James E. Baker, FDIC Enf. Dec. ¶5199 (1993); In the Matter of Veil David DeVillier, FDIC Enf. Dec. ¶5202 (1993); In the Matter of Richard M. Roberson, FDIC Enf. Dec. ¶5211 (1994); and In the Matter of Allan Hutensky, FDIC Enf. Dec. ¶5224 (1995), aff'd. 82 F.3d 1234 (2nd Cir. 1996). Id. at A-2839, fn. 4. Aside from the brevity of the so-called "history" (1992-1995), there are important and clearly distinguishing factual characteristics between the cited cases and the case involving Glen Garrett. [In the Matter of Glen Garrett, FDIC Enf. Dec. ¶11,599 (1999)]

First, it may be noted that if the FDIC were truly convinced that "nominee" loans were made in the Garrett case, a removal action would have been initiated to be consistent with the cited FDIC "significant history" of removal actions. Since a removal action was not instituted (FDIC witnesses admitted under cross- examination that consideration of such an action was abandoned in August of 1994 after being first recommended by FDIC examiners in November of 1991), it is probably safe to assume (or at least argue) that the FDIC is itself unsure of whether the loans in question actually qualified as "nominee" loans. [The presiding Administrative Law Judge in Garrett (ALJ Shipe) decided not to require the FDIC witnesses to explain why the proposed removal action was abandoned.]

As detailed below, there are significant factual differences between Candelaria (and the cases cited therein) and the Garrett case. For example, in Candelaria, the respondent was the loan officer and made all of the loans in question; the named borrower did not know that any of the loans had been made or that the respondent had signed the promissory notes for the borrower; the named borrower never received the proceeds of the loans; the respondent deposited the proceeds of the loans directly into his personal checking account; the named borrower never acknowledged liability for repayment of the loans; and the respondent actually repaid the loans in question. None of those factual characteristics were present in the Garrett case.

Each of the decisions cited in Candelaria show similar factual characteristics that distinguish those cases from the Garrett action. The following factual statements (to be answered true or false) serve as a good starting point to illustrate such differences:

The respondent was actively involved in the loan application process.
The respondent participated (either directly or indirectly) in the loan approval process.
The respondent acted as the loan officer for the named borrower.
The named borrower was not aware of the loan transaction when made.
The named borrower did not receive any of the loan proceeds.
The respondent was the only person who received the loan proceeds.
The named borrower never acknowledged liability to repay the loan.
The named borrower did not repay any of the principal of the loan.
The respondent admitted liability for repayment of the loan.
The respondent repaid the principal of the loan.
The named borrower did not pay any of the interest due on the loan.
The respondent made all of the interest payments on the loan.

All of the foregoing statements were "true" in Candelaria. At best, only 2 were partially true in Garrett. [Glen Garrett made most (but not all) of the interest payments, thus making the last two statements partially true.]

The importance of the Candelaria decision is centered on the specific direction provided by the FDIC Board in determining how to identify a loan transaction as a "straw-party" or "nominee" loan. The opinion pinpoints the "crucial issue" to be determined is the question of determining the identity of the person who is legally responsible for repayment of the loan:

Respondent stresses that [the named borrower] could not be a "fictitious" borrower, because she is a real person and her real social security number was on the [loan] documents. Respondent avoids the crucial issue here, which is whether the named borrower is the person who is responsible for the repayment of the loan. When the named borrower is not the person responsible for the loan, in common banking parlance such person is a "fictitious" borrower. Neither Respondent nor [the named borrower] expected or wanted [the named borrower] to have any of the proceeds or be liable for payment of the principal or interest on these loans.1
[Id. at A-2839, fn 4; emphasis added.]

The discussion in Candelaria of what constitutes a "fictitious" borrower is incomplete. All "nominee" borrowers are not "fictitious" borrowers. A nominee borrower is a real person who acts as a conduit or front for the "true" borrower who is the person who receives the loan proceeds and who has agreed to be responsible for the repayment of the loan obligation. A nominee borrower does not receive any consideration or benefit from the transaction and therefore is not liable or legally responsible for the repayment of the loan. A nominee may well have participated in the loan transaction, but with the "understanding" (usually pursuant to an oral side-agreement with the person who received the proceeds) that he or she will not be liable for any payment of principal or interest on the loan. On the other hand, a fictitious borrower is a named borrower who either does not exist, or (if the named person does exist) is totally unaware of the fact that a loan was made in his name. In Candelaria, the named borrower was a real person, but was totally unaware of the fact that a loan had been made by the respondent in her (the named borrower's) name. Thus, such loan was correctly labeled in Candelaria as a loan to a "fictitious" borrower. In the present case, of course, the "crucial issue" of liability for the repayment of the loans has been addressed twice in sworn affidavits executed by the named borrowers, and was reaffirmed under oath for a third time when they testified. Such testimony was corroborated further by documentary evidence which showed that the funds used to repay the loans were provided by the named borrowers, not Garrett.

The recommended decision in Candelaria was written by ALJ Shipe who recommended a one-year removal ban, citing the actions of respondent as misguided "errors of judgment." The FDIC Board reversed and issued a permanent removal and prohibition order. If ALJ Shipe found favor with the respondent in Candelaria, he might have awarded a medal to Glen Garrett. In this regard, it should be remembered that the respondent in Candelaria personally made the loans and received the proceeds without ever telling the named borrower that such loans had been made. If ALJ Shipe was sympathetic with such conduct, he must have been astounded by the FDIC's reaction to Glen Garret's conduct. It might also be worth noting that ALJ Shipe presided over the hearing in the Roberson case cited in Candelaria. As discussed below, Roberson has the most egregious set of factual circumstances in all of the cases cited in Candelaria.

What is the relevance of Regulation O to FDIC actions involving "nominee" loans?

None of the "nominee" loans in Candelaria were alleged as violations of Regulation O. The FDIC based its action for removal upon three elements: (1) unsafe and unsound practice, (2) personal dishonesty, and (3) continuing disregard [recklessness] for the safety of bank - all of which are elements for removal under section 8(e) of the Federal Deposit Insurance Act. None of the loans in question were alleged to be in violation of any law or regulation - even though a violation of law is an alternative element under the removal statute.

A review of the "nominee" loan cases cited in Candelaria follows and shows a "mixed bag" of results regarding the relationship of Regulation O to "nominee" loans. In most cases, Regulation O is simply used (via the tangible economic benefit rule of construction) to attribute the loans in question to respondent with the result that the attributed loans when added to other direct extensions of credit culminate in a violation of the lending limit restriction in Regulation O. The fact that a loan is made to a "nominee," standing alone, is not relied upon or cited as a violation of Regulation O. [In only one case (Hutensky) has the FDIC Board made a direct connection between a resulting consequence of a "nominee" loan (viz., an alleged fiduciary duty to inform the board) and a violation of Regulation O. As discussed below, the analysis of the FDIC Board in Hutensky is wrong.]

In the Matter of Veil David DeVillier, FDIC Enf. Dec. ¶10,689 (1992)

A Removal Order was issued by consent in DeVillier. There is no indication in the published decision and order that "nominee" loans were involved or that such loans constituted violations of Regulation O. This is only ascertainable (albeit by assumption) from the cited 1993 civil money penalty case [discussed below] involving the same respondent.

In the Matter of James E. Baker, FDIC Enf. Dec. ¶5199 (1993)

Baker involved a removal action for series of five loans (all made on the same date) totaling over $2 Million by three affiliated banks for the benefit of respondent's father who was the principal shareholder of holding company which owned the three banks and who served as chairman of all three banks. The named borrowers included respondent, his father, his aunt, and two business associates of respondent's father. Respondent was an officer and director in two of the three banks and was the loan officer for all but two of the loans in question. All of the loans were in amounts that exceeded the bank's lending limit under Regulation O (and state law) if such loans were attributable to respondent's father who had a large preexisting debt at the time the loans in question were made. At that time, respondent's father was facing a foreclosure action on a loan secured by the holding company's stock. All of the proceeds of the loans in issue were eventually transferred to and used by respondent's father to prevent such foreclosure. Respondent's father had previously consented to a removal order for his involvement in the same loans.

The opinion in Baker concludes that all five of the loans were attributable to respondent's father under the tangible economic benefit rule of Regulation O and were therefore made in violation of the lending limit prohibition in that regulation. [The prohibition against loans with "unfavorable features" is never mentioned in Baker.] Even though all of the loans were documented as being made to facilitate purchases of holding company stock from respondent's father, they were actually repaid (with one exception) by funds received from respondent's father, thus confirming their "nominee" or "straw-party" status.

The sole exception pertained to the loan made to respondent's aunt, who insisted that she had in fact purchased stock from her brother. The FDIC Board conceded the bona fide nature of the aunt's stock purchase noting that she was creditworthy for the loan and that the evidence showed she actually repaid her loan with her own funds. Nevertheless, the decision concludes that her loan is attributable to respondent's father (the named borrower's brother), citing an old 1986 case that originated in 1984. See FDIC Enf. Dec. ¶5199 at A-2283, fn. 7. [The cited 1986 case was a consolidated C&D and CMP action and did not involve any "nominee" loans; all were regular loans that were either "unsafe and unsound" and/or in excess of the Regulation O loan limit.] In Baker, therefore, the only relevance of Regulation O to the existence of "nominee" loans was the fact that the loans resulted in overline violations of Regulation O.

The Baker opinion is wrong in attributing the loan made to respondent's aunt to respondent's father under the tangible economic benefit rule in Regulation O. Although not discussed (and perhaps never even considered), the then unwritten exception to the tangible economic benefit rule would have precluded a finding that a violation of the lending limit prohibition had occurred. Such exception states that if a loan is made for the purpose of purchasing property (such as stock) from an insider in a bona fide arms-length sales transaction (which the opinion in Baker concedes), such loan will not be attributed to the insider for purposes of Regulation O. One of the loans in Baker was made to respondent's aunt to enable her to purchase stock from an insider (her brother). The aunt's stock purchase transaction was bona fide, was made on arms-length terms and conditions, and the loan was serviced and repaid by the aunt. As such, the loan was clearly exempt from the tangible economic benefit rule. The exemption (which is based on Federal Reserve and FDIC staff opinions) was eventually codified into Regulation O in 1994. 12 C.F.R. § 215.3(f)(2).

In the Matter of Veil David DeVillier, FDIC Enf. Dec. ¶5202 (1993)

This was an action for the assessment of a CMP of $15,000 for multiple violations of Regulation O. After obtaining a consent removal order against the same person in 1992, the FDIC issued an assessment notice for over $500,000 in 1993. As indicated, the final CMP order was only $15,000.

In DeVillier, there were three separate classes of violations of Regulation O: (1) personal checks in violation of the overdraft, loan limit, prior approval, and preferential terms prohibitions, (2) three "nominee" loans to relatives (mother and brother) for respondent's personal benefit, and (3) a series of personal loans made directly to respondent. All of the loans further aggravated a preexisting overline situation. Respondent had borrowed almost twice the bank's lending limit. With regard to the three "nominee" loans, two loans (which totaled $65,000) were made to respondent's mother ostensibly to reimburse respondent for amounts he had extended to her for her support. The decision [aside from factual circumstances that distinguish it from Garrett] concludes (correctly) that the loans were attributable to respondent under the tangible economic benefit rule and that they resulted in additional overline and prior approval violations of Regulation O.

Interestingly, the opinion in DeVillier also concludes that the two loans made to respondent's mother also violated the preferential terms and "unfavorable features" prohibition in Regulation O; however, there is no indication how or on what basis that conclusion was reached. In sharp contrast, the third "nominee" loan to respondent's brother was not classified as a violation of the preferential terms and "unfavorable features" prohibition. See FDIC Enf. Dec. ¶5202 at A-2296. Thus, without any comment or explanation by the FDIC Board, two of the "nominee" loans are summarily characterized in DeVillier as violations of the "unfavorable features" prohibition in Regulation O, while the third "nominee" loan is not. There is no clue why such distinction was made.

The emphasis in DeVillier is clearly on the overdrafts and the overline and prior approval prohibitions in Regulation O. The applicability of the "unfavorable features" prohibition in Regulation O is never discussed; it is simply concluded (almost as an aside) in respect of two of three "nominee" loans without any explanation.

In the Matter of Richard M. Roberson, FDIC Enf. Dec. ¶5211 (1994)

A Removal Order was issued in Roberson after respondent first failed to answer the FDIC charges and later failed to offer any evidence at a "hearing" ordered by the FDIC to overcome the default order problem noted in Amberg, et al. v FDIC, 934 F.2d 681 (5th Cir. 1991).

The FDIC action in Roberson was well-founded and documented. [The FDIC Board simply adopted the recommended decision by ALJ Shipe which followed the one-sided "hearing."] As a direct consequence of loans made by respondent, he received benefits (including kickbacks) in excess of $300,000, and the bank sustained losses in excess of $5 Million, which included a loss of $850,000 for five "accommodation" loans. [The term "nominee "loan is not used in the opinion.] The loans were made as part of an elaborate scheme devised by respondent (who was the loan officer in all cases) to circumvent the lending restrictions of Regulation O and applicable state law, and there was clear and undisputed evidence of concealment and repeated attempts by respondent to hide the true circumstances pertaining to the loans in question. The "accommodation" loans were never repaid and resulted in a loan loss of $850,000.

All of the violations cited Roberson pertain to the lending limit restriction of Regulation O. None of the loans in question were cited as violations of the "unfavorable features" prohibition, which is somewhat ironic. [It is difficult to imagine a factual scenario that involves more "unfavorable features" than that presented in Roberson. It would not be surprising if that case also resulted in respondent's criminal conviction of more than one felony.]

In the Matter of Allan Hutensky, FDIC Enf. Dec. ¶5224 (1995)

This case involved a removal action based on three transactions that in the aggregate totaled $11 Million. Two of the transactions involved loans (which totaled $1.5 Million) that were made to persons who transferred the loan proceeds to a related interest of respondent, and one transaction involved respondent's participation (concealing material information) in a decision by the board to modify a loan (which totaled $9.5 Million) that had been made previously to a related interest of respondent, who was an attorney and board member. All three transactions were cited and upheld as violations of Regulation O.

The first two loans are characterized in the opinion as "nominee" loans, noting that prior FDIC cases have used the term "accommodation" loan to describe the same type of loan. The decision in Hutensky concludes that the loans resulted in violations of the prior approval requirement of Regulation O. The prohibition in Regulation O against loans to insiders with "unfavorable features" is never mentioned in the Hutensky opinion.

There is extensive discussion in the Hutensky decision of the facts and circumstances of the two loans in support of the conclusion that they were "nominee" loans. For example, the candid testimony of respondent clearly indicates that the loans were intended to serve the purpose of the related interest (which received the proceeds) as opposed to those of the named borrowers; the named borrowers did not take an active role in obtaining the loans (it was all done for them at the direction of respondent); the bank never made any effort to establish the creditworthiness of the named borrowers; and the named borrowers never intended to use (and, in fact, never did use) their own funds to repay the loans. [Indeed, the FDIC Board noted that the recommended decision of ALJ Alprin had correctly pinpointed the identity of the source of the repayment as "the very heart of the Regulation O issue." Id. at A-2539, fn. 15.] Based upon such facts, it is easy to agree with the conclusion of the FDIC Board in Hutensky that the two loans in question were "nominee" loans.

The most troublesome aspect of the Hutensky opinion stems from the apparent conclusion that "nominee" loans (or at least those involved in that case) violated Regulation O. The issue was first raised when respondent noted in an exception to the recommended decision that the FDIC pleadings had only charged that the loans were "unsafe and unsound" and not violations of Regulation O. In response, the FDIC Board (while conceding the technical accuracy of the exception) points out that the pleadings specifically alleged that respondent "failed to disclose" that the loan was being made to a "nominee," and also that respondent "failed to make full disclosure" to the bank that his related interest would receive the proceeds of the loans in a related transaction with the named borrower. Without any explanation, the opinion then makes the sweeping conclusion that both allegations regarding a failure to disclose "clearly set forth the elements of violations of Regulation O." See FDIC Enf. Dec. ¶5224 at A-2536. [See also, the "Additional Findings of Fact and Conclusions of Law" recited in the opinion which state (in typical summary fashion) that respondent's failure to make the proper disclosures constituted violations of the preferential terms and prior approval requirements of Regulation O. Id. at A-2544. (Because of their large size, the loans in Hutensky required prior board approval - an element which was not present in Garrett.)]

The FDIC Board in Hutensky did not provide any type of rationale or basis for the conclusion that respondent's failure to make proper disclosures to his board constituted a violation of Regulation O. At the time the two loans in question were made in 1989 and 1990, Regulation O did not contain any disclosure requirement applicable to respondent. Such requirement was not made applicable to FDIC-regulated banks until 1992. 12 C.F.R. § 215.5(d)(1). On the other hand, there is discussion in Hutensky regarding the conclusion of why respondent's failure to disclose constitutes a breach of fiduciary duty; however, the opinion seems to simply assume (or make a leap of faith) that a violation of Regulation O is also established. See FDIC Enf. Dec.¶5224 at A-2539-40 and the discussion of the Lowe case (respondent had affirmative duty to notify board of intended benefit to related interest). The plain fact of the matter, however, is that a breach of fiduciary duty is not a violation of Regulation O. [It appears that the applicability of the prior approval requirement in Regulation O to the loans in Hutensky coupled with the finding of an intentional breach of fiduciary duty by an attorney that occurred in connection with implementing such prior approval requirement combined to form the logical conclusion that such a culpable breach also constituted a violation of Regulation O. Such reasoning may be logical, but is flawed from the standpoint of legal soundness.]

The FDIC decision in Hutensky to remove respondent is probably well-founded in both fact and law. There was a clear unsafe and unsound practice (and possibly a breach of fiduciary duty), and there was more than ample evidence to support the other statutory elements of a removal action. But the same cannot be said for the finding of a violation of Regulation O. There is simply no evidence (or law) to support the determination by the FDIC Board that respondent's failure to make proper disclosures to the board constituted a violation of Regulation O. As indicated, the disclosure requirement in section 215.5(d) of Regulation O was not made applicable to insured nonmember banks until 1992 following the enactment of FDICIA.

The phrase "unfavorable features" is never used by FDIC Board in the Hutensky decision.

The decision of the Second Circuit Court of Appeals in Hutensky v. F.D.I.C., 82 F.3d 1234 (2nd Cir. 1996) upheld the violations of Regulation O, but remanded the case for further findings pertaining to the culpability requirement for removal under section 8(e)(1)(C). In upholding the violations of Regulation O, the Second Circuit analysis was focused solely upon two provisions of Regulation O. First, it noted that Regulation O contained a "prior approval" requirement in section 215.4(b)(1) for certain "extensions of credit" to insiders; and second, it noted that section 215.3(f) defined "extension of credit" to include loans where proceeds were transferred to insider. Hutensky argued that the loans in question were made to bona fide borrowers who were legally liable and therefore not "nominees" (for which no prior approval was required), and that there were actually two transactions when the named borrowers subsequently transferred the proceeds to his related interest. In rejecting the argument, the Court reasoned:

Regulation O provides that "[a]n extension of credit" is considered made to a person ... to the extent that the proceeds ... are used for the tangible economic benefit of, or are transferred to, such person." §215.3(f) (emphasis added). This language does not tie a finding of an "extension of credit" to the nominal debtor's understanding of his repayment obligation or his ability to meet that obligation.

The problem with the Hutensky case is that the loans in question were styled or characterized as "nominee" loans by FDIC. Hutensky argued they were not, pointing out that the borrowers acknowledged legal liability to repay the loans. [Hutensky was a bank insider and had failed to notify the board of directors that the proceeds of the loans were to be transferred to his related interest.] The analysis of the Second Circuit is correct. The tangible economic benefit rule of construction in section 215.3(f) ["TEB rule"] is not conditioned upon a finding regarding liability to repay the loan. Stated differently, a "nominee" loan and a loan under the TEB rule are not the same. All covered loans under the TEB rule is not necessarily "nominee" loans. Thus, a determination that a particular loan is not a "nominee" loan does not preclude a finding that it is a covered loan under the TEB rule.

The importance of the appellate decision in Hutensky is that the violation of Regulation O upheld by the reviewing court is specifically tied to the "prior approval" requirement in section 215.4(b) of Regulation O. The loans in question were sufficiently large to trigger such requirement - a critical factor which was not present in the Garrett case. Thus, the conduct of Respondent Hutensky of failing to inform the Board of his interest in the proceeds of the loans directly facilitated the violation of the requirement of prior approval by the Board. The Hutensky opinion does not conclude that Regulation O imposes a duty on insiders to disclose their interests in loans to the board, and that Regulation O was violated because of a breach of that duty. Rather, the Court of Appeals for the Second Circuit in Hutensky held:

Hutensky violated Regulation O when he failed to obtain the prior approval [of the board of directors] of the [loans in question].
[Emphasis added.]

Nevertheless, the holding in Hutensky clearly embodies the existence of a duty to make certain disclosures to the board. But it is equally clear that such duty is imposed only in connection with an analysis of the obligation of a bank insider to implement and facilitate the fulfillment of the prior approval requirement of Regulation O. This same reasoning and conclusion is also reflected in the decision of the Eleventh Circuit in Lowe v. FDIC. [There is a separate discussion of the Lowe case in a companion comment.] There is nothing in either Hutensky or Lowe to suggest that Regulation O imposes a duty of an insider to make disclosures to the board outside of the context of the prior approval requirement.2 Accordingly, in the absence of any requirement pertaining to prior approval, there is nothing in either decision which says that Regulation O is violated if an insider fails to notify the board of his interest in the proceeds of a loan made to a third party. In this regard, it is significant that the Hutensky decision specifically refrained from making any determination whether such failure constituted a breach of fiduciary duty or unsafe or unsound banking practice. [Id. at 1241, fn. 9]

ENDNOTES

1. Interestingly, the FDIC Board did not cite or rely upon the undisputed fact that the respondent had admitted he was legally responsible for repayment of the loans in question, thus answering the "crucial issue" to be determined.

2. Regulation O was amended in 1992 to incorporate a specific disclosure requirement for all nonmember banks which mandated that executive officers (but not directors or institution affiliated parties) notify the board of any receipt of the proceeds of a loan made by the bank. [See section 215.5(d)(1) of Regulation O.] Prior to that amendment, therefore, an executive officer of a nonmember bank only had a duty to disclose his or her interest in the proceeds of a loan made by the bank in the context of determining whether the prior approval requirement of Regulation O was satisfied vis-à-vis the holding in the Lowe decision. [The amendment in Regulation O was necessitated as a result of FDICIA which made both subsections (g) and (h) of section 22 of the Federal Reserve Act applicable to nonmember banks. See section 18(j)(2) of the Federal Deposit Insurance Act. Prior to FDICIA, nonmember banks were not subject to section 22(g) of the Federal Reserve Act, which was implemented by section 215.5 of Regulation O.]

 

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