How Regulation W Affects Subscription Credit Facilities

Executive Summary

Section 23A of the Federal Reserve Act and its implementing regulation, Regulation W, impose restrictions on banks concerning “covered transactions” with their affiliates. With the increasing intertwining of banking institutions and private investment funds, understanding the implications of Regulation W is more critical than ever. In this Legal Update, we explain the scope of Regulation W, its requirements, and how it affects subscription credit facilities, including guidance from the Federal Reserve Board, and suggestions for how banks can comply with Section 23A when providing covered credit facilities.

Background

Given the abundance of private investment funds, it is increasingly common for banks to invest in or advise investors in these funds and also lend to these funds. However, Section 23A of the Federal Reserve Act (12 USC 371c) restricts “covered transactions” among banks and their affiliates. These restrictions aim to safeguard the bank's safety and soundness—and by extension, the government's exposure through mechanisms like the discount window and deposit insurance—by regulating transactions with affiliates.¹ To determine whether Section 23A’s restrictions apply to a given transaction requires a two-prong assessment to determine whether the transaction (i) involves a bank and an “affiliate” of the bank and (ii) qualifies as a “covered transaction” under Regulation W.

What to Know About Regulation W

What is an “Affiliate” Under Section 23A?
Section 23A defines “affiliate” broadly as any entity that controls, is controlled by, or is under common control with another entity (in this case, a bank), including:

Any company in which a majority of its directors, trustees, or general partners (or individuals exercising similar functions) constitute a majority of those persons holding similar roles in the bank or its controlling entity.
Any company, including a real estate investment trust, receiving sponsorship and advisory services on a contractual basis from the bank or an affiliate.
Any investment fund for which the bank or an affiliate acts as an investment adviser.
Certain portfolio companies of private equity funds that are controlled by an affiliate of the bank.²

What is Considered a Covered Transaction?
Covered transactions encompass a broad variety of financial dealings between a bank and one of its affiliates, including loans and other extensions of credit, investments in affiliate securities, acquisitions of assets, and other transactions that expose the bank to the credit risk of its affiliates. Common examples of covered transactions are:

Extending credit to an affiliate, including granting a line of credit or changing the terms of the credit facility (e.g., increasing the amount, extending the maturity date, or adjusting the interest rate).
Purchasing or investing in a security issued by an affiliate.
Purchasing an asset from an affiliate, including assets subject to recourse or agreements for repurchase, unless specified by the Federal Reserve as exempt.
Accepting a security issued by an affiliate as collateral for extending credit to any individual or entity.
Issuing guarantees, acceptances, or letters of credit, including endorsements or standby letters of credit, on behalf of an affiliate, confirming letters of credit issued by an affiliate, and cross-affiliate netting arrangements.³
Using loan proceeds to repay another financing issued by an affiliate of the bank.
Derivative transactions in which the bank has a credit exposure to the affiliate.

In the fund finance market, covered transactions most often arise in the following scenarios:

An affiliate of the lending bank is an investor in the fund.
The bank acts as an adviser in the transaction.
The bank provides a hedge, purchases a fund asset, or accepts securities issued by an affiliate of the bank.
The proceeds of the subscription credit facility are used for the benefit of, or transferred to, an affiliate of the bank.

What are Section 23A’s Requirements for Covered Transactions with Affiliates?
Section 23A dissuades banks from engaging in covered transactions with their affiliates by setting both quantitative limitations and collateral requirements and prohibiting purchases of low-quality assets. The quantitative limit sets a ceiling on the total value of covered transactions permitted at any given time, providing an incentive for banks to utilize their 23A capacity cautiously. Specifically, Section 23A prohibits banks from engaging in a covered transaction with an affiliate if, after the transaction, either (i) the total amount of the bank’s covered transactions with that specific affiliate would exceed 10% of the bank’s capital stock and surplus; or (ii) the total amount of the bank’s covered transactions with all affiliates combined would exceed 20% of the bank’s capital stock and surplus.

A statutorily defined collateral mandate further manages a bank’s credit exposure to its affiliates resulting from covered transactions, requiring collateral valued at least equal to the loan amount, and sometimes up to 130%, based on the type of collateral, which can impose higher-than-market conditions on credit extensions in a covered transaction to affiliates. Specifically, Section 23A requires that any credit transaction between a bank and its affiliate be secured by collateral having the following minimum market value:

Type of Collateral	Minimum Collateral Value Required
US Government Obligations⁴	100%
State or Political Subdivision Obligations	110%
Other Debt Instruments (e.g., Capital Commitments)	120%
Stock, Leases, Real or Personal Property	130%

The regulation also specifies collateral that is ineligible (including intangible assets, such as capital call rights, unless specifically approved by the Federal Reserve). With respect to the offered collateral, the bank is obligated to maintain a perfected first priority security interest in the offered collateral, subject to rules applicable to senior liens. This security interest must be legally enforceable under relevant laws, including in scenarios involving bankruptcy, insolvency, liquidation or similar circumstances. If the bank’s security interest in the collateral is not the first priority, it is required to subtract from the collateral’s value the lesser of two amounts: (i) the amount of any security interest in the collateral that is senior to the bank’s interest; or (ii) the amount of credit secured by the collateral that is senior to the bank’s claim. As a result, all loans and other covered transactions with affiliates must be collateralized, and sometimes—depending on the nature of the collateral—overcollateralized.

Are There Any Exemptions to Section 23A’s Requirements?
Section 23A sets forth several transaction types between a bank and its affiliates that are fully or partially exempt from its quantitative limitations and collateral requirements, including:

Providing credit to an affiliate secured entirely by cash or US Treasuries;
Acquiring assets from an affiliate with readily identifiable and publicly available market values;
Extending credit for items in the collection process; and
Repurchasing loans sold to an affiliate with recourse.

How Does Section 23A Affect Subscription Credit Facilities?
Given the expansive definitions of an affiliate and a covered transaction, complying with Section 23A is imperative for entities engaging in subscription credit facilities. Because subscription credit facilities may be extensions of credit from banks to bank affiliates, they may be subject to Section 23A. Additionally, Section 23A incorporates an “attribution rule,” which deems a transaction between a bank and a third party a covered transaction if the funds from the transaction are utilized for the benefit of, or transferred to, an affiliate of the bank. Accordingly, lenders should:

Require borrowers to provide detailed information regarding the utilization of loan proceeds to ensure adherence to Section 23A; and
Include provisions in the loan documents that obligate fund borrowers to track and report any use of loan proceeds by the fund for the benefit of third-party recipients.

In certain instances, these requirements can be limited to recipients that potentially could be affiliates of the lender.

As mentioned above, Section 23A mandates collateral for loans or credit extensions to affiliates, ranging from 100% to 130%, depending on the collateral’s type. In the case of subscription credit facilities, the transaction likely would be covered under the 120% requirement for debt instruments. The collateral amount is determined at the inception of the transaction, based on the amount of the outstanding credit extended and the market value of the offered collateral at that time. If any portion of the collateral subsequently amortizes or retires, it must be replaced with additional eligible collateral to preserve the required minimum collateral value percentage. Banks extending credit through subscription credit facilities need to monitor capital commitment levels closely to ensure that collateral supporting the credit facility meets the requirements of Section 23A, both initially and on an ongoing basis.

Recent Staff Guidance

On December 30, 2021, the Federal Reserve released supplementary responses to frequently asked questions (“FAQs”) concerning Regulation W. Most relevant to subscription credit facilities is the Federal Reserve’s statement that if the bank’s initial transaction qualifies for an exemption, the attribution rule should not be applied to a series of transactions (e.g., subsequent extensions of credit under the same credit facility) so long as (i) the transactions were not structured to evade the requirements of Section 23A of Regulation W and (ii) the bank maintains reasonable Regulation W compliance procedures and processes, such as those suggested above, that monitor the use of transaction proceeds.

In addition, the Federal Reserve staff stated that they generally would not recommend an enforcement action if a bank did not know or have reason to know at the time of the transaction that transaction proceeds might be utilized for a prohibited purpose. As a result, banks should focus on maintaining a robust Regulation W compliance program and exercise due diligence in connection with subscription credit facilities so such lenders can provide evidence supporting their knowledge of potential affiliate transactions.

Takeaways

Determining the extent of the applicability of Section 23A or Regulation W to a particular subscription facility arrangement requires a thorough analysis of the applicable fund structure. Given the complex regulatory landscape, the broad scope of key defined terms, and the Federal Reserve mandate for a sound understanding of a transaction’s use of proceeds, funds and lenders alike must carefully evaluate their financing arrangements under a subscription credit facility to ensure initial compliance with the regulation, as well as appropriate monitoring for ongoing compliance. As banks continue to navigate the complexities of lending to funds in which they may have affiliated interests, adhering to Section 23A's requirements is essential to maintain regulatory compliance and financial stability.

¹ Lenders should also be aware of “Super 23A”, a part of the Volcker Rule, codified at 12 USC 1851 and implemented by 12 CFR pts. 44, 248, 351 and 17 CFR pts. 75, 255. Super 23A outright prohibits banks and their nonbank affiliates from engaging in covered transactions with a covered fund they own, sponsor, manage, or advise, with certain exceptions. We separately discussed Super 23A in a Legal Update.

² Section 223.2 of Regulation W.

³ Section 223.3(h) of Regulation W.

⁴ These are (i) obligations of the United States or its agencies; (ii) obligations fully guaranteed by the United States or its agencies as to both principal and interest; (iii) notes, drafts, bills of exchange, or bankers' acceptances eligible for rediscount or purchase by a Federal Reserve Bank; or (iv) a segregated, earmarked deposit account with the bank, specifically designated for securing credit transactions between the member bank and its affiliates.