4000 - Advisory Opinions
Apparent Violation of Section 332.1 of FDIC Regulations
September 7, 1982
Rae Schupack, Regional Counsel
You asked for a legal interpretation as to whether *** Bank violated section 332.1 of FDIC regulations by guaranteeing a bank customer's loan to the Small Business Administration (SBA) in the amount of $17,600.
The facts are these: ***, a bank customer, had more than $150,000 in loans at the bank. Mr. ***'s farming operation was not successful, and he was having increasing trouble in servicing these debts. In addition to his debts at the bank, Mr. *** owed $17,600 to the SBA on a disaster assistance loan. The bank urged Mr. *** to arrange to have as much of his bank debt as possible refinanced elsewhere. He obtained a loan commitment from John Hancock Life Insurance Company (Hancock Insurance) for $140,000; Hancock Insurance, however, required a first mortgage on all of Mr. ***'s land (160 acres). The SBA held a first mortgage on this land in connection with the disaster loan. When approached, the SBA agreed to subordinate its mortgage to a first lien in favor of Hancock Insurance, but only if the bank or Hancock Insurance would guarantee the payment of the $17,600 owed to SBA. The bank provided the guarantee SBA requested.
On its face, this transaction seems to fall within the scope of section 332.1 of FDIC regulations which prohibits the bank from guaranteeing or becoming surety upon the obligations of others. However, the Legal Division has recognized an implied exception to this prohibition. If a bank has a "substantial interest" in the performance of an obligation, independent of the guarantee or surety, then the bank may act as guarantor or surety of that performance.
In my view, the bank had a substantial interest in guaranteeing Mr. ***'s $17,600 SBA loan to facilitate the refinancing. By doing so, the bank was able to limit its potential for loss to a maximum of $17,600. If the transaction had not taken place when it did, the bank's potential for loss would have been much greater, both in amount and in likelihood. The refinancing put Mr. *** in a position wherein he was better able to pay all of his debts, including the $17,600 debt the bank guaranteed. The refinancing also moved the loan out of the bank, thereby strengthening the bank's loan portfolio, it freed up $140,000 which otherwise would have been tied up in a single farmer's already unsuccessful operation and allowed this money to be available for lending to stronger borrowers.
If default had occurred, the bank would have been forced to foreclose and to liquidate Mr. ***'s farming operation. The resulting loss probably would have substantially exceeded $17,600. In addition, such a foreclosure would have meant bad public relations for the bank. A bank's goodwill always suffers when it sells out a large farmer in a small community.
The bank's other option would have been on its own to refinance Mr. *** with a longer term loan and lower monthly payments. This, however, would have been imprudent because it would have tied up too much money (relative to the bank's size) for a long time in a single loan to a farmer who already was known to be unsuccessful. ***
***, by arranging to have Mr. ***'s debt refinanced at Hancock Insurance and limiting its potential loss, the bank acted prudently under the circumstances.
I notified the bank of my determination that this transaction falls within the "substantial interest" exception to the section 332.1 prohibition against guarantees by banks. (I attached a copy of my letter to the bank.) If you have any further questions about this matter, please do not hesitate to give me a call.