# O

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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

##### Interpretive Letter #956

#### January 31, 2003 February 2003 

**12 USC 24(7)**

Re: Request for Opinion

Dear **\[ \]**:

This letter is in response to your request for a legal opinion
confirming the permissibility of several aspects of an agreement entered
into by **\[ *Bank* \]**, **\[ *City, State* \]** ("Bank") and **\[
\]**, a California corporation ("**\[ \]**"). The Bank and **\[ \]**
have executed an Opportunity Development Agreement ("Agreement"),
pursuant to which the Bank finances **\[ \]**'s purchase of real
properties and then benefits from the appreciation in such properties.
You have requested that we confirm that this lending arrangement is
permissible pursuant to Interpretive Ruling 7.1006, 12 C.F.R. § 7.1006
(2002), the OCC's regulation permitting national banks to take a share
of the borrower's profits as part of the interest on the loan. You have
also requested that we confirm that each of the lender covenants imposed
by the Bank as part of the financing it provides to **\[ \]** is legally
permissible. Finally, you have requested that we confirm that the nature
of compensation paid by the Bank to **\[ \]** is consistent with OCC
precedent. For the reasons discussed below, we confirm each of your
requests.

**A. Background**

As represented by the Bank, the facts are as follows. The relationship
between the Bank and **\[ \]**'s principals ("the Principals") began in
the 1980s when the parties entered into an agreement for the Principals
to manage certain of the Bank's other real estate owned ("OREO")
portfolio. Based upon the Principals' successful management of the OREO
assets, the Bank and **\[ \]** entered into the Agreement.

Pursuant to the Agreement, **\[ \]** seeks out potential real estate
investment opportunities for the Bank to finance. After identifying an
opportunity, **\[ \]** gathers comprehensive information regarding the
property and presents that information to the Bank to assist the Bank in
evaluating the lending opportunity.[^1] The Bank then applies its
underwriting criteria to determine whether to make the loan. If the Bank
extends credit for **\[ \]** to purchase the property ("Bank Loan"), the
purchase money for the property consists of the proceeds of the Bank
Loan (95 percent) and an equity contribution from the Principals (five
percent). With limited exceptions, each Bank Loan has been an unsecured,
five-year loan with an eight percent rate of interest. The Agreement
requires that **\[ \]** personally manage each property after purchase.

In consideration for the performance of **\[ \]**'s services, the Bank
contributes to the cost of **\[ \]**'s general expenses, including the
expenses associated with the pre-investment evaluation of potential real
property financing opportunities. The Bank does so (i) by providing **\[
\]** with office space and associated services and (ii) by contributing,
each calendar quarter, \$100,000 for **\[ \]**'s expenses.[^2] Once the
Bank approves a Bank Loan, the deal-specific expenses are included in
the loan to **\[ \]** if the deal is consummated or, if not consummated,
the expenses are shared 95 percent by the Bank and five percent by **\[
\]**.

In addition to the Bank Loans, the Bank has a right of first refusal to
provide conventional, secured commercial financing to either **\[ \]**
or the business entity in which **\[ \]** is investing ("Primary Loan").
Even if the Bank chooses to make a Bank Loan, it may decline to make a
Primary Loan. The Bank has made several Primary Loans secured by the
ultimate real estate assets; in other instances, another lender has made
the Primary Loan.

The Agreement provides for the use of funds received by **\[ \]**,
whether realized from the sale or refinance of a property or from some
other source. These funds are used first to repay principal and interest
on the Primary Loan and the principal amounts of the Bank Loan and the
Principals' equity contribution. Any remaining funds are used next to
pay the base interest amount on the Bank Loan and to provide the
Principals with a base return on their equity contribution. Finally,
**\[ \]** pays any remaining funds as contingent interest, in the amount
of 80 percent to the Bank and 20 percent to **\[ \]**.[^3]

Consistent with its role as a lender, the Bank imposes certain lender
covenants to protect its loans to **\[ \]**.

-   First, the Bank conditions the continuation of the Agreement upon
    the Principals' maintaining 100% ownership of **\[ \]**;

-   Second, the Bank requires that the Principals maintain a personal
    services agreement with **\[ \]**, pursuant to which they agree to
    devote as much time as "reasonably necessary for a satisfactory
    performance of their duties";

-   Third, the Bank precludes **\[ \]** from purchasing properties not
    financed by Bank Loans;

-   Fourth, the Bank retains approval rights upon the sale of a portion
    (as opposed to all) of a real property and the distribution of **\[
    \]**'s assets;

-   Fifth, the Bank imposes a debt to equity ratio of 19-to-1 in cases
    where it provides the Bank Loan. As described above, the Bank
    finances 95 percent of the acquisition costs and **\[ \]**'s
    Principals put up the remaining five percent; and

-   Sixth, the Bank requires **\[ \]** to provide various financial
    statements and reports.

#### B. Discussion

***1. The Lending Arrangement***

*a. Interpretive Ruling 7.1006, 12 C.F.R. § 7.1006*

The OCC has long recognized the authority of national banks to share in
the profit, income, or earnings from a business enterprise as a full or
partial substitute for interest on a loan. Interpretive Ruling 7.1006
provides that:

> \[a\] national bank may take as consideration for a loan a share in
> the profit, income, or earnings from a business enterprise of a
> borrower.... The share ... may be taken in addition to, or in lieu of,
> interest. The borrower's obligation to repay principal, however, may
> not be conditioned upon the value of the profit, income, or earnings
> of the business enterprise ...

This ruling recognizes that extensions of credit may take many forms. In
order for national banks to have a greater degree of flexibility in
their lending activities, Interpretive Ruling 7.1006 makes clear that
repayment of an extension is not necessarily limited to a bank's receipt
of principal and a specified amount of interest on a demand or
installment basis over time.[^4] Moreover, this ruling represents the
OCC's long-standing position on the authority of national banks to
employ participatory financing arrangements. In November 1966, the OCC
added Paragraph 7312 to the "Comptroller's Manual for National Banks."
Paragraph 7312 provided that:

> \[a\] national bank may take as consideration for a loan a share in
> the profit, income or earnings from a business enterprise of a
> borrower. Such share may be in addition to or in lieu of interest. The
> borrower's obligation to repay principal, however, shall not be
> conditioned upon the profit, income, or earnings of the business
> enterprise.

Several interpretive letters in 1969 and 1970, citing to Paragraph 7312,
confirmed that a national bank could accept a share in the profit,
income, or earnings of a business enterprise as consideration for a loan
in lieu of interest or partially in lieu of interest.[^5] However, the
authority to share in the profit, income, or earnings from a business
enterprise as a full or partial substitute for interest pursuant to
Interpretive Ruling 7.1006 is subject to certain limitations. These
limitations are designed to ensure that the bank's role in providing
such financing is that traditionally assumed as a lender.[^6] First,
there must be no risk to loan principal other than that arising from a
borrower's default; in this regard, Interpretative Ruling 7.1006
requires that the obligation to repay principal shall not be conditioned
upon the profit, income, or earnings of the business enterprise. Second,
in keeping with the provisions of 12 U.S.C. §§ 24(7) and 29, a national
bank can have no possessory or ownership interest in a borrower's
business or real estate.

Within these parameters, a national bank may calculate its share of the
profit, income, or earnings on the basis of either the appreciation of
the borrower's business or the appreciation of individual assets.[^7]
The OCC has never limited the amount of contingent interest -- in the
form of a share of the profit, income, or earnings -- that a national
bank may accept. Rather, OCC precedent treats the percentage of profit,
income, or earnings that a bank accepts as a contractual matter to be
agreed upon by the parties.

Based upon the facts as represented, we find that the arrangement, as
described, between the Bank and **\[ \]** is permissible pursuant to
Interpretive Ruling 7.1006. The Bank provides financing for **\[ \]** to
acquire real properties. The principal of these loans is not at risk,
beyond the general default risk inherent in any loan transaction. **\[
\]** is obligated to pay the principal and base interest on all
outstanding loans regardless of the ultimate profitability of any
transactions financed by the Bank. Moreover, the Bank has not assumed a
possessory or ownership interest in **\[ \]**'s business or any real
property. By agreeing to "take as consideration for a loan a share in
the profit, income, or earnings from a business enterprise" of **\[
\]**, the Bank is merely exercising its authority under Interpretive
Ruling 7.1006. The Bank's share is based upon the available funds of
**\[ \]** as a business enterprise, and such basis is consistent with
Interpretive Ruling 7.1006. Finally, because OCC precedent treats the
percentage of profit, income, or earnings that a bank accepts as a
contractual matter to be agreed upon by the parties, the Bank's 80
percent share is consistent with such precedent.

*b. Lender covenants*

From a national banking perspective, it is sound public policy for banks
to include covenants in their lending relationships.[^8] Indeed, the
more lender covenants that a bank includes, the more protection the bank
has. In this case, the Bank imposes a series of lender covenants. First,
the Bank conditioned continuation of the Agreement upon the Principals'
maintaining 100 percent ownership of **\[ \]**. Second, the Bank
required the Principals to enter into a personal services agreement with
**\[ \]**. With respect to both covenants, the Bank believes that the
Principals' continued involvement is essential to the overall success of
its relationship with **\[ \]** and the on-going stability of the Bank's
unsecured loans. We find that these covenants are permissible prudential
measures designed to protect the Bank's position given the limited
purpose of **\[ \]** and the Bank's unsecured position.

Third, the Bank precludes **\[ \]**'s purchase of properties not
financed by Bank Loans. The Bank's outstanding loans to **\[ \]** are
unsecured and its contingent interest payment is based upon the success
of **\[ \]**. The Bank believes it has a vested interest in ensuring
that **\[ \]**'s subsequent investments are economically sound. We find
that this covenant is a permissible prudential measure designed to
protect the Bank's position given the limited purpose of **\[ \]** and
the Bank's unsecured position.

Fourth, the Bank imposes approval rights upon the sale of a portion (as
opposed to all) of a real estate property and the distribution of **\[
\]**'s assets. The Bank believes doing so protects its right to be
repaid on its outstanding loans. We find that this covenant is a
permissible prudential measure designed to protect the Bank's position
given the limited purpose of **\[ \]** and the Bank's unsecured
position.

Fifth, the Bank imposes a debt to equity ratio of 19-to-1 in cases where
it provides the Bank Loan. The Bank does so to ensure that **\[ \]** has
an equity interest in each transaction. We find that this covenant is a
permissible prudential measure designed to protect the Bank's position
given the limited purpose of **\[ \]** and the Bank's unsecured
position.

Sixth, the Bank requires **\[ \]** to provide various financial
statements and reports to permit the Bank to monitor the financial
condition of the business. We find that this covenant is a permissible
prudential measure designed to protect the Bank's position given the
limited purpose of **\[ \]** and the Bank's unsecured position.

Finally, we find that these covenants, taken collectively, are a
permissible prudential measure designed to protect the Bank's position.

***2. Compensation Paid by Bank to \[ \]***

Rather than paying a per-loan fee, the Bank compensates **\[ \]** for
its services by providing **\[ \]** with office space and paying a
portion of **\[ \]**'s operating expenses.

Twelve C.F.R. § 7.1004(a) provides that "a national bank may use the
services of, and compensate persons not employed by, the bank for
originating loans." As a legal matter, the OCC has neither specified nor
limited the nature and amount of compensation that a bank may pay a
third party for originating loans.[^9] Therefore, the nature and amount
of the Bank's compensation to **\[ \]**, in the form of office space and
expenses, is consistent with OCC precedent.

#### C. Conclusion

For the reasons discussed above, we conclude that the Bank's lending
arrangement with **\[ \]** is permissible pursuant to Interpretive
Ruling 7.1006. We further conclude that the lender covenants described
above, individually and collectively, are permissible prudential
measures designed to protect the Bank's position. Finally, we conclude
that the nature of compensation paid by the Bank to **\[ \]** is
permissible. If you have any questions about the foregoing analysis,
please feel free to contact me at (202) 874-5300.

Sincerely,

Eric Thompson

Eric Thompson

Director

Bank Activities & Structure Division

[^1]: The Agreement provides that neither **\[ \]** nor its principals
    are employees or agents of the Bank. Further, the Agreement states
    that the Bank and **\[ \]** are not engaged in a partnership or
    joint venture.

[^2]: One-half of this amount is reimbursable out of **\[ \]**'s cash
    flow. Pursuant to the personal services agreement entered into by
    the Principals, which is described *infra*, **\[ \]** pays the
    Principals \$45,000 each quarter for their services.

[^3]: The Agreement also provides that, prior to the payment of
    contingent interest, **\[ \]** must use any remaining funds to pay
    the Bank an amount equal to the full principal amount of any other
    Bank Loan as to which the Bank has determined that the prospect of
    repayment from the related real property underlying such Bank Loan
    is for any reason impaired.

[^4]: *See* Letter from John G. Heimann, Comptroller of the Currency
    (May 21, 1980) (unpublished); Letter from Charles F. Byrd, Asst.
    Director, Legal Advisory Services Division (Oct. 18, 1977)
    (unpublished).

[^5]: Letter from Patrick Parise, Regional Counsel (Oct. 16, 1970)
    (unpublished) (warrants); Letter from Thomas G. DeShazo, Deputy
    Comptroller of the Currency (Aug. 26, 1969) (unpublished) (profits);
    Letter from Robert Bloom, Chief Counsel (May 26, 1969) (unpublished)
    (warrants). In 1971, the OCC codified Paragraph 7312 as Interpretive
    Ruling 7.7312, 12 C.F.R. § 7.7312. The current ruling, Interpretive
    Ruling 7.1006, replaced Interpretive Ruling 7.7312 without
    substantive change in April 1996.

[^6]: *See*, *e.g.,* Interpretive Letter No. 620, *reprinted in*
    \[1993-1994 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 83,502
    (July 15, 1992); Interpretive Letter No. 204, *reprinted in*
    \[1981-1982 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶85,285
    (June 17, 1981).

[^7]: Interpretive Letter No. 244, *reprinted in* \[1983-1984 Transfer
    Binder\] Fed. Banking L. Rep. (CCH) ¶ 85,408 (Jan. 26, 1982) (bank
    may accept a set percentage of the sales price upon sale of each
    developed real estate unit; bank may also accept a set percentage of
    the appreciation in the value of a business developed and operated
    on the mortgaged property); Interpretive Letter No. 216, *reprinted
    in* \[1981-1982 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶
    85,297 (Sep. 8, 1981) (bank may accept a set percentage share of the
    net appreciation of the mortgaged property at the end of a stated
    term).

[^8]: *See* Interagency Guidelines for Real Estate Lending Policies, at
    Appendix A to Subpart D of 12 C.F.R. part 34. *See generally*
    Comptroller's Handbooks, "Agricultural Lending" (Dec. 1998), "Loan
    Portfolio Management" (Apr. 1998), and "Commercial Real Estate and
    Construction Lending" (Nov. 1995).

[^9]: *See* Letter from Charles F. Byrd, Assistant Director, LASD
    (October 30, 1977) (unpublished). As a supervisory matter, the bank
    must not compensate the third party in a manner that adversely
    affects the safety and soundness of the bank.