Duane Morris Banking and Finance Law

Regulation W excludes from the definition of ‘affiliate’ any company that is engaged solely in holding the premises of the relevant bank. Under 12 CFR 223.2(b)(2), this exclusion allows banks to structure real property holdings through a separate entity without triggering affiliate transaction restrictions. But the exclusion is extremely narrow.

To qualify for this exclusion, the premises-holding company must meet all of the following conditions:

(1) it must engage only in holding real property;

(2) that property must be used exclusively by the bank and any Regulation W “sister” bank;

(3) no portion of the property may be leased to external parties; and

(4) the company may not hold any other assets or engage in any other activities.

The term “solely” is critical. If the premises-holding company owns even a single non-real-property asset, or if any portion of the building is subleased to a third party such as a retail tenant or ATM operator, the exclusion is lost. At that point, the company becomes an affiliate, and any further dealings with it become covered transactions subject to quantitative limits and collateral requirements.

This interpretation reflects the Board’s intent that this exclusion serve only the limited purpose of allowing banks to hold their own operating premises in a separate legal entity for liability or tax reasons.

DM Tip: If your bank uses a separate entity to hold its premises, conduct a periodic audit to ensure the entity holds only bank premises, has no outside tenants, and engages in no other activities. Even a minor deviation, such as leasing parking spaces to a neighboring business, could disqualify the exclusion.

Globalization brings unique compliance challenges under Regulation W. One scenario illustrates this well: If a foreign government controls both a bank and another company, is that company an affiliate of the bank?

The answer is yes. Under 12 CFR 223.2, common control by any entity, including a foreign government, creates an affiliate relationship. The affiliate definition does not distinguish between domestic and foreign controlling entities, nor does it exempt sovereign or governmental controllers.

This means that if a foreign sovereign wealth fund or government ministry controls a bank and also controls another company, those entities are affiliates for Regulation W purposes. All covered transactions between the bank and that commonly controlled company are subject to the 10 percent individual limit, the 20 percent aggregate limit, collateral requirements, the low-quality asset prohibition, and the market-terms requirement of Section 23B.

The twin purposes of Sections 23A and 23B, as articulated by the Federal Reserve, are to protect against losses from affiliate transactions and to limit transfers of the federal safety net subsidy to affiliates. These purposes apply regardless of whether the controlling entity is a domestic holding company or a foreign government.

DM Tip: If your bank has any foreign government ownership or control, map out all entities controlled by that same government. Treat all commonly controlled entities as affiliates and ensure all transactions are monitored under your Regulation W compliance program.

One of the “covered transaction” categories under Section 23A of the Federal Reserve Act and Regulation W is the issuance of a guarantee or letter of credit by a bank “on behalf of an affiliate.” But what exactly does ‘on behalf of’ mean here?

The Federal Reserve has clarified that a guarantee or letter of credit is issued “on behalf of” an affiliate when the affiliate is the account party, not the beneficiary. In other words, it is a transaction where the bank promises to make a payment to a nonaffiliate if the affiliate defaults on an obligation to that nonaffiliate.

This definition traces back to the 1982 Senate Report (S. Rep. No. 97-536) and a 1982 Federal Reserve Bulletin article. The key distinction is between: (1) transactions where the bank backstops the affiliate’s obligations to third parties (a “covered transaction”), and (2) transactions where the affiliate happens to be the beneficiary of a letter of credit the bank issues for a nonaffiliate customer (not a “covered transaction” in the same sense).

The “covered transaction” amount is the full face value of the guarantee or letter of credit, regardless of the probability of the affiliate actually defaulting. This conservative approach reflects the potential for the bank’s resources to be called upon to satisfy the affiliate’s obligations.

DM Tip: Before issuing any guarantee or letter of credit where an affiliate has any role or is any way related to the transaction, carefully determine whether the affiliate is the account party (triggering Regulation W) or merely the beneficiary. Document the analysis and ensure the transaction counts toward quantitative limits if the affiliate is the account party.

We previously discussed a scenario where a bank indemnifies its parent holding company to determine if it becomes a “covered transaction” under Regulation W. However, the opposite scenario is equally important: if a holding company indemnifies its subsidiary bank in a service contract for bank losses caused by the negligence or willful misconduct of the holding company, this also does not create a covered transaction.

This makes intuitive sense. When the holding company indemnifies the bank, the bank is the beneficiary, not the one at risk. Section 23A of the Federal Reserve Act and Regulation W are designed to protect the bank from transactions that expose it to affiliate risk, not to restrict arrangements where the affiliate compensates the bank for the affiliate’s own wrongdoing.

However, banks should be careful about the scope and direction of indemnification. The non-covered-transaction treatment applies specifically where the indemnifying party is agreeing to cover losses it caused. If an indemnification clause were structured so that the bank effectively guarantees the holding company’s performance to third parties, that could constitute a guarantee on behalf of an affiliate, which is a covered transaction.

The distinction turns on who benefits and who bears the risk. If the bank receives protection from the affiliate’s misconduct, there is no covered transaction. If the bank provides protection to or on behalf of the affiliate, that analysis changes entirely.

DM Tip: Review all intercompany service agreements to ensure indemnification clauses are properly scoped to cover only losses caused by the indemnifying party’s own conduct. Flag any clause where the bank appears to be assuming risk for affiliate-caused losses, as that may require Regulation W treatment.

Regulation W applies to several transactions involving “securities,” including purchases of or investments in securities issued by an affiliate and acceptance of affiliate securities as collateral. But how does the Federal Reserve define “securities”?

The Federal Reserve generally looks to the federal securities laws for guidance, as confirmed in the 2002 preamble to its Final Rule implementing Regulation W. This means the definition of “security” under Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Exchange Act of 1934 provides the framework.

Under federal securities law, the term “security” is interpreted broadly to include stocks, bonds, debentures, notes, investment contracts, and a wide range of other instruments. The Supreme Court’s Howey test for investment contracts and the Reves “family resemblance” test for notes provide additional guidance for instruments that are not clearly labeled.

This broad interpretation means that banks should not assume an instrument falls outside Regulation W simply because it is not a traditional stock or bond. Partnership interests, LLC membership interests, certain loan participations, and structured products may all qualify as securities depending on their characteristics.

DM Tip: When evaluating whether an instrument issued by an affiliate constitutes a “security” for Regulation W purposes, apply the federal securities law definitions broadly. When in doubt, treat the instrument as a security and comply with Regulation W requirements. Document your analysis, especially for novel or hybrid instruments

If a bank and an affiliate engage in an asset exchange, where the bank gives one asset and receives another, is this a purchase of assets by the bank from the affiliate? The answer is yes, unless the asset being received by the bank is cash.

This distinction is important for structuring intercompany transactions. If the bank exchanges a portfolio of loans for a different portfolio of loans held by an affiliate, that constitutes a purchase of assets from an affiliate, a covered transaction subject to quantitative limits, collateral requirements, and the low-quality asset prohibition.

However, if the bank exchanges an asset for cash from the affiliate, that is simply a sale by the bank to the affiliate, which is not a covered transaction from the bank’s perspective (though it may be subject to Section 23B’s market-terms requirement).

The practical distinction matters in corporate reorganizations and portfolio rebalancing within holding company structures. Banks should be aware that any non-cash asset received from an affiliate in an exchange triggers Regulation W’s full suite of protections.

DM Tip: When contemplating asset swaps with affiliates, consider whether the transaction can be restructured as two separate cash transactions (bank sells for cash, then buys separately) rather than a direct asset exchange. If a direct exchange is necessary, ensure the assets received are measured and counted against your Regulation W limits.

Here is a practical scenario: a bank previously sold an asset to an affiliate with recourse (meaning the affiliate can require the bank to repurchase if the asset goes bad). The asset has since become a low-quality asset. May the bank repurchase it?

Yes, provided the asset was not a low-quality asset at the time the bank originally sold it. This is an important safe harbor. The policy rationale is that the bank’s recourse obligation was established when the asset was healthy, and the bank should be able to honor its pre-existing contractual commitment even though the asset has since deteriorated.

However, if the asset was already a low-quality asset when the bank first sold it to the affiliate, the bank may not repurchase it. The low-quality asset prohibition in 12 CFR 223.15 prevents a bank from purchasing low-quality assets from affiliates, and this prohibition would apply to the repurchase.

This distinction highlights the importance of timing and documentation. Banks that sell assets to affiliates with recourse should document the asset’s quality status at the time of sale, including any examination classifications, to support a future repurchase if necessary.

DM Tip: If selling assets to affiliates with recourse, document the asset’s classification status at the time of sale. Maintain this documentation throughout the recourse period so that, if repurchase becomes necessary, you have clear evidence that the asset was not a low-quality asset when originally sold.

Under Regulation W, a bank generally may not purchase a “low-quality asset” from an affiliate. But what exactly qualifies as a low-quality asset, and can an asset escape that status through restructuring?

A low-quality asset includes, among other things, assets classified by examiners as “‘”substandard,” “doubtful,” or “loss.” The question arises: if a classified asset is restructured, does it lose its low-quality status? The answer is no. The asset remains a low-quality asset until it is re-examined and de-classified by bank examiners.

This is a strict rule. The bank cannot unilaterally determine that restructuring has cured an asset’s low-quality status. Only an independent examination and explicit de-classification by examiners can remove the low-quality label. This prevents banks from engaging in cosmetic restructurings to circumvent the low-quality asset purchase prohibition.

The practical impact is significant for banks contemplating asset purchases from affiliates. Even if an affiliate has restructured a loan and the borrower is now current, the bank cannot purchase that asset from the affiliate unless examiners have affirmatively removed the classified designation.

DM Tip: Before purchasing any asset from an affiliate, obtain the most recent examination classification status. Do not rely on restructuring, cure, or current payment status alone. If the asset was previously classified, confirm in writing with your examiners that it has been formally de-classified before completing the purchase.

Sometimes a guarantee does not look like a traditional guarantee. Consider the following: a bank pledges its own collateral to secure a borrowing made by an affiliate from a third-party lender. Is this a guarantee by the bank on behalf of the affiliate?

Yes. The Federal Reserve treats a bank’s pledge of collateral to secure an affiliate’s borrowing as a guarantee on behalf of the affiliate for purposes of Regulation W. The covered transaction amount is the lesser of: (i) the market value of the pledged collateral; or (ii) the amount of the borrowing.

This interpretation, confirmed in a 1993 General Counsel opinion, makes economic sense. When the bank pledges its assets to secure an affiliate’s debt, the bank is effectively promising the lender that its assets will be available to satisfy the affiliate’s obligation if the affiliate defaults. That is the functional equivalent of a guarantee.

The measurement as the lesser of collateral value or borrowing amount reflects the actual exposure. If the bank has pledged collateral worth less than the full borrowing, its maximum exposure is the collateral value. If the collateral exceeds the borrowing, the exposure is limited to the borrowing amount because that is all the lender can claim.

DM Tip: Audit all instances where bank assets are pledged to secure obligations of any affiliate. Each such arrangement should be booked as a guarantee for Regulation W purposes, measured at the lesser of collateral market value or the secured obligation amount, and included in quantitative limit calculations.

Regulation W applies to transactions between a bank and its affiliates, but the definition of “affiliate” requires that the counterparty be a “company.” This raises a fundamental question: what qualifies as a company for Regulation W purposes?

The answer excludes sole proprietorships – a sole proprietorship is not a company for purposes of Regulation W. This means that even if an individual who operates a sole proprietorship also controls a bank, the sole proprietorship itself cannot be an affiliate of the bank under Regulation W.

This distinction is rooted in the definition of “company” under banking law, which generally encompasses corporations, partnerships, limited liability companies, business trusts, and similar organizations, but not unincorporated businesses operated by a single individual in their personal capacity.

However, banks should not treat this as a blanket safe harbor. Transactions with sole proprietors who are insiders may still be subject to other regulatory requirements, including Regulation O governing insider lending, and general safety and soundness standards. Additionally, the attribution rule could apply if loan proceeds to a sole proprietor are transferred to an affiliated entity.

DM Tip: While sole proprietorships fall outside Regulation W’s affiliate framework, ensure your compliance program still captures transactions with sole proprietors who are insiders or who may transfer proceeds to affiliated entities. Cross-reference your Regulation O and Regulation W monitoring systems.