The Central Bank has now issued its Code of Practice on Lending to Related Parties (the “Code”) which applies from 1 January 2011 to all licensed banks, building societies and credit institutions designated under the Asset Covered Securities Act, 2001. The Code will not apply to Irish branches of banks authorised in other EU jurisdictions but it will apply to Irish authorised subsidiaries. Breach of the Code may result in administrative sanction or the prosecution of an offence by the Central Bank.
The Code is one element of an ongoing process to address a variety of issues which came to light in the domestic banking industry over the course of the financial crisis. The scale and complexity of certain arrangements between banks and their directors and senior managers have given rise to serious concern. The level of disclosure relating to such arrangements has also been seriously lacking in certain instances. The Code is intended to address these and other governance issues concerning related party lending.
The Code will apply to all loans, quasi-loans and credit transactions (including guarantees) entered into between a bank and any “related party” or their “connected persons” at any time, whether before or after the Code becomes effective. Although a pre-existing arrangement will not contravene the Code, banks will need to conduct a thorough review of such arrangements, and if any such arrangement falls within the scope of the Code, must take all possible steps to modify the arrangement to make it consistent with the Code.
Who is a Related Party?
Under the Code a “Related Party” is defined as “a director, senior manager or significant shareholder of the credit institution or an entity in which the credit institution has a significant shareholding, as well as a connected person of any of the aforementioned persons”. There are a number of difficulties associated with the interpretation of this definition which we will return to below.
Key Provisions of the Code
- The Board of a bank (or a sub-committee of that Board established specifically to deal with related party lending) must individually approve related party loans and any action in respect of the management of a related party loan. Loans to a related party exceeding EUR1,000,000 will require prior approval of the Central Bank.
- Related party lending must be subject to a written process of ongoing monitoring by “Senior Management” and that process must be approved in advance by the Board. Senior Management must report any deviation from a policy, process or limit required by the Code to the Board at least quarterly. The bank must report any such deviation to the Central Bank within 5 business days;
- Related party loans must not be on more favourable terms than equivalent transactions with a non-related party (except as part of staff remuneration packages pre-approved by the Board).
- Banks must implement policies and processes:-
- to identify related party loans and monitor and report on such loans through an “independent credit review process”;
- to prevent members of staff from receiving additional benefits arising from related party lending that they would not otherwise receive and to prevent persons related to a borrower being part of the process of granting and managing a loan to that borrower.
- Lending to related parties is prohibited where it would result in exposures exceeding limits set out in the Code. Broadly these are:-
- for exposures to the banks’ directors, senior management and their “connected persons” – individual exposures of 0.5% and aggregate exposures of 5% of own funds;
- for exposures to “significant shareholders” in the bank (apart from other credit institutions) and businesses in which the significant shareholder has a significant shareholding – individual exposures of 5% and aggregate exposures of 15% of own funds. A “significant shareholding” for this purpose is 10% or more.
- for exposures to clients or a group of connected clients (apart from other credit institutions) in which the bank has a “significant shareholding” – individual exposures of 5% and aggregate exposures of 15% of own funds.
The Code requires that related party exposures be reported to the Central Bank on a periodic basis and in a format specified by the Central Bank. The consultation paper with respect to the Code indicated that this reporting obligation would supersede Sections 8(a) to (c) of the licensing and supervision requirements and standards for credit institutions although this is not expressly stated in the Code.
Changes following Consultation Process
A number of changes have been made to the original text of the Code issued as part of the consultative process. The primary changes are as follows:-
Delegation to Sub-Committee of Board
- Language has been introduced providing that approval and management of related party loans can also be carried out by a sub-committee of the Board formed specifically to deal with related party lending, where that sub-committee reports directly to the Board. This provision may have been introduced in response to observations that decisions regarding entry into related party loans and the ongoing monitoring of such loans are normally conducted at management level in a bank, subject to policies and procedures laid down by the Board. The Code effectively elevates those functions to Board level (or by virtue of the change, a sub-committee of the Board). Banks will accordingly need to put in place processes which enable the Board or sub-committee to perform these functions.
Definition of Loan
- The definition of “Loan” for the purposes of the Code has been expanded to include quasi-loans and credit transactions (terms taken from the Companies Act 1990) and also to include guarantees. This has significantly broadened the application of the Code, however, the purpose of the Code would have been significantly undermined were it not to catch, for example, guarantees on behalf of related parties or other transactions whereby a bank assumes a credit exposure on behalf of a related party.
Central Bank Approval
- The requirement referred to above that loans to a related party exceeding EUR1,000,000 require Central Bank approval.
Reporting of Deviations
- The requirement that banks report deviations from the Code within 5 business days. The Code also provides that Senior Management are obliged to report at least quarterly to the Board on any such deviation. It is not clear whether the 5 business days is to run from the date upon which the quarterly report is delivered to the Board or from when the deviation is originally discovered or occurs.
Sanctions and Offences
- New language has been introduced to make it clear that a contravention of the Code may result in the Central Bank using any of its regulatory powers, which may include the imposition of an administrative sanction under the Central Bank Act 1942 or the prosecution of an offence.
Key Issues to be considered
Intra - group Lending
The Code has the potential to significantly impact on the freedom of banks to conduct intra-group lending. The restrictions arise out of the definition of “Related Party” which includes a “significant shareholder of the credit institution or an entity in which the credit institution has a significant shareholding, as well as a connected person of any of the aforementioned persons”. A significant shareholding for this purpose is 10% or more of the relevant shares or voting rights.
Consequently, subsidiaries of a bank will be Related Parties for the purposes of the Code. Arising from that, all of the restrictions in the Code to do with Related Party lending will apply to intra-group lending.
The Code does provide that an exemption from the limits on exposures referred to above may be sought in respect of intra-group lending, provided the relevant parties to that intra-group lending are supervised on a consolidated basis with the bank
This exemption only applies to the exposure limits and not to the other requirements of the Code. Consequently, a loan to a subsidiary may not be granted on more favourable terms than the bank would offer to a non-related party and the prior approval of the Central Bank will be required for lending to any subsidiary which exceeds EUR1,000,000.
Intra-group lending is a normal element of the financing structure of any group of companies and intra-group loans are often not made on terms which would be offered to a third party. This is not normally of concern because such lending is conducted intra-group. It is not clear what risk or potential abuse is intended to be captured by these measures in the Code and the restrictions may significantly limit the capacity of banks to implement funding structures which are a normal and conventional element of group financing structures.
Arising from this, banks will need to conduct a thorough review of their existing intra-group lending arrangements to assess compliance with the provisions of the Code and will need to introduce policies and procedures to ensure compliance from 1 January 2011. On a broader level, consideration will need to be given to the practical implications for intra-group financing on an ongoing basis.
Role of the Board
As indicated above, the Code expects the Board of each affected bank (or a specially appointed sub-committee) to oversee all related party lending by that bank. As indicated above, this may well necessitate significant changes to the existing lending practices and procedures within banks and represents a significant additional responsibility for the Board. It will be important for banks to ensure that such actions on the part of the Board or its sub-committee are supported by all necessary processes and procedures within the bank concerned.
Identifying Related Parties
A significant difficulty (which was identified by a number of parties who made submissions as part of the consultative process) is that the definition of “Related Party” gives rise to uncertainty as to who precisely will be a “Related Party” for the purposes of the Code. Briefly, the main difficulties are as follows:-
- Related Parties include “senior managers” of a bank. It is unclear from the definition of “Senior Management” used in the Code whether that term only applies to executives who report directly to the Board and/or the Chief Executive or whether it also applies to other “management” within the bank.The word "management" does not have a specific legal meaning and could cover a very broad group of persons in the bank. Given this uncertainty, banks will have to take a view on who is to be considered “Senior Management” for this purpose.
- The definition of “Related Party” also includes “significant shareholders” of the bank. The definition of “significant shareholder” refers to a person who “holds” the relevant shares. While the word “holds” is capable of being interpreted as applying only to the legal interest in the relevant shares, the safer interpretation is to regard it as applying to both legal and beneficial interests. The practical difficulty with this interpretation is that seeking to identify who holds a beneficial interest in shares can be time consuming and inconclusive.
- The definition of “Related Party” also refers to “connected persons” of directors, senior managers and significant shareholders. There are also difficulties with the definition of “connected persons” for this purpose, primary among those being the following:-
- there is reference to the “domestic partner” of a person. This is not a phrase which has a precise legal meaning.
- there is reference to two persons constituting a single risk where one has “control” over the other. “Control” for this purpose is not defined and, from a legal perspective, is a phrase susceptible to multiple interpretations;
- there is also reference to parties constituting a single risk where, notwithstanding that one does not “control” the other, they are so “interconnected” that “if one of them were to experience financial problems, the other or all of the others would be likely to encounter repayment difficulties”. From a legal perspective there are multiple scenarios where persons could be considered to be connected in this way and it is unclear precisely how broad the ambit of this particular sub-category is.
Consequently, it will be very difficult for banks to determine precisely who are to be considered “Related Parties” for the purposes of the Code and, accordingly, to introduce processes and procedures to track loans to all of those persons. As was pointed out in a number of the submissions, it may not be possible as a practical matter to determine who all of the “connected persons” of a particular individual are because a bank is not entitled to require that person to provide the relevant information. Even if a credit institution had enhanced rights to obtain this information or it was submitted voluntarily, the difficulties in interpretation referred to above militate against any “bright line” in this regard.
For the present, each bank will have to take a view on how far it needs to go in identifying who are to be considered Related Parties for this purpose.
The Code requires that related party loans must be monitored and reported on “through an independent credit review process”. It is not clear what kind of process will satisfy this requirement. No guidance is offered in the Code itself. Once again, banks will need to take a view on what is necessitated by this requirement.
It is generally accepted that robust controls in relation to related party lending, which will ensure that conflicts of interest and other abuses can be avoided, are necessary. In fact, banks already operate within a legal and regulatory framework which addresses these risks to a significant extent.
Broadly speaking, the reaction to the Code, so far as it can be deduced from the content of the submissions made as part of the consultative process, is not a fundamental objection to the introduction of the kind of measures described in the Code. There are however significant concerns about precisely how the Code is to be applied in practice and the fact that certain requirements appear to go further than is necessary given the underlying purpose of the Code.
Notwithstanding these concerns, the Code is now in place and banks will need to quickly take such action as is required to ensure compliance with it. In our view it will be important for banks to be able to demonstrate compliance through production of a clearly documented “audit trail”. The actions to be taken should be reviewed and authorised by the Board and should include all necessary changes to existing procedures and, if required, additional training. The steps to be taken and such process of review and authorisation should be clearly documented.
As part of our submission on the Code, we suggested that difficulties arising in the application of the Code could be addressed through providing for a system whereby the Central Bank would issue private rulings or guidelines in relation to its interpretation of particular provisions of the Code and its view on problematic situations arising in implementing the Code. To the extent that it considered it appropriate to do so, the Central Bank could also issue public guidance where issues in implementing the Code were arising repeatedly and were of sufficient uniformity to enable guidance of general application to be given. We think that such a system could be of considerable value in assisting credit institutions in complying with the Code and would significantly add to its effectiveness.