[Federal Register Volume 60, Number 76 (Thursday, April 20, 1995)]
[Proposed Rules]
[Pages 19690-19693]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-9616]



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NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Part 701


Organization and Operations of Federal Credit Unions

Agency: National Credit Union Administration (NCUA).

Action: Proposed rule.

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Summary: National Credit Union Administration (NCUA) Rules and 
Regulations prohibit officials and certain employees of federally 
insured credit unions from receiving either incentive pay or outside 
compensation for certain activities related to credit union lending. 
The regulations are ambiguous in places and have proved difficult to 
interpret. Further, the regulations may be too restrictive in some 
instances and too broad in others. The NCUA Board is proposing to amend 
the regulations to make them clearer, to authorize lending-related 
compensation in certain situations where it is currently prohibited, 
and to prohibit it in other situations. If amended as proposed, it 
should be easier for credit unions to determine when incentives may be 
paid and easier for officials and employees to determine whether they 
may accept compensation for outside activities.

Dates: Comments must be postmarked or posted on NCUA's electronic 
bulletin board by June 19, 1995.

Addresses: Mail comments to Becky Baker, Secretary of the Board, 
National Credit Union Administration, 1775 Duke Street, Alexandria, VA 
22314-3428. Send comments to Ms. Baker via the bulletin board by 
dialing 703-518-6480.

For Further Information Contact: Lisa Henderson, Staff Attorney, (703) 
518-6561, at the above address.

SUPPLEMENTARY INFORMATION:

Background

    Section 701.21(c)(8) of the NCUA Rules and Regulations, 12 CFR 
701.21(c)(8), prohibits federal credit unions from making a loan if, 
either directly or indirectly, any commission, fee, or other 
compensation is to be received by the credit union's directors, 
committee members, senior management employees, loan officers, or any 
immediate family members of such individuals, in connection with 
underwriting, insuring, servicing, or collecting the loan. However, 
non-commission salary may be paid to employees. As a condition of 
federal insurance pursuant to Section 741.3(a) of the Regulations, 12 
CFR 741.3(a), the prohibition applies to federally insured state-
chartered credit unions. The purpose of Section 701.21(c)(8) is to 
ensure that an individual who is in a position of authority in a credit 
union does not put self-interest ahead of the credit union's interest 
in making good loans and providing good service to its members. The 
provision prohibits compensation from third parties and from the credit 
union itself, in the form of commissions, incentive pay, or bonuses.
    Under the current regulation, a ``loan officer'' is an individual 
who has the authority to approve a loan. A loan officer may or may not 
be involved in taking and processing loan applications. ``Underwriting 
the loan'' means approving or disapproving it. Thus, an individual who 
has any part in approving a loan is prohibited for receiving incentive 
pay in connection with that loan. An individual who is involved in 
processing a loan, but who has no role in its approval or disapproval, 
may receive incentive pay in connection with the loan.
    The prohibition against making a loan if a commission or fee is to 
be received by a loan officer in connection with insuring the loan 
means, for example, that the individual who has the authority to 
approve a loan may not receive an incentive for selling credit life or 
disability insurance on it.
    Noting that credit union management had become increasingly 
interested in implementing lending-related incentive pay programs, the 
NCUA Board, on March 9, 1994, issued a Request for Comment on whether 
Sec. 701.21(c)(8) should be amended to permit loan officers and/or 
senior management to receive incentive pay for underwriting and 
insuring loans, 59 FR 11937 (March 15, 1994). A total of 252 comments 
was received, 177 of which expressed support for allowing incentive pay 
for loan officers. Most of the latter suggested that incentive pay be 
permitted only with controls in place.
    A number of commenters described the success their credit unions 
had had with incentive programs involving employees other than loan 
officers; they argued that even greater benefits would accrue from 
paying incentives to loan officers. Most of these programs seem to have 
been implemented in the past few years, however, and some of the 
information submitted to the Board raises questions about whether they 
will be successful in the long run.
    For example, information submitted by one commenter cites research 
which has shown that incentive programs can fail in the long term 
because employees become preoccupied with meeting goals and fail to 
carry out their normal routines. When management sets a specific goal, 
and offers a reward for meeting it, work or problems that do not relate 
to that goal are ignored. Cooperative spirit between people often 
diminishes because each has different goals and becomes wrapped up in 
his or her own work. Incentive pay can actually work to undermine an 
employee's internal motivation to perform well, as employees end up 
working for the incentive rather than the satisfaction of the work 
itself. Employees can also be demoralized by the underlying assumption 
that they are not working hard and need incentives to perform.
    One credit union commenter learned about the risks of incentive 
programs the hard way. He reported that his credit union's incentive 
program for loan officers was unsuccessful for the following reasons: 
(1) Despite controls being in place, some loan officers exceed their 
authority in approving [[Page 19691]] loans. The commenter noted that 
even if a loan officer can be disciplined for poor judgment, ``once a 
loan is made, you can't take it back.''; (2) Incentives caused disputes 
among loan officers, each of whom thought the others were receiving 
more favorable treatment from management by having more creditworthy 
loans routed to them; and (3) Incentives caused some animosity between 
employees who were eligible for incentive pay, such as those in the 
loan department, and those who were not.
    Other commenters argued that incentives are not necessary for 
successful loan programs. One commenter provided details of how his 
credit union had dramatically improved productivity after eliminating 
all incentives. He reported that the credit union's consumer loan 
approval ratio had increased from 62% to 84% as a result of 
centralizing the origination function and implementing a credit scoring 
system. The credit union also improved service to members by providing 
loan decisions within 24 hours and making the terms and pricing of its 
products more competitive. In two years, the consumer loan portfolio 
increased by 38% while loan delinquencies and charge-off ratios 
remained better than the credit union's peer group. As a result of 
improved terms and pricing of mortgage products, originations increased 
from $62 million in 1991 to $161 million in 1993.
    Despite misgivings about incentive pay, the Board recognizes the 
strong arguments made by many commenters that if incentive pay can be 
offered in a manner that protects against abuses, the decision whether 
to do so should be a management decision, not one that is precluded by 
an overly restrictive regulation. Therefore, the Board is proposing to 
allow credit unions to provide incentive pay to some employees, 
including loan officers, in certain circumstances, as described below.-

Proposed Regulation

    The proposed rule changes the structure of the regulation to a 
broad prohibition, with specific exceptions, against an official or 
employee receiving compensation in connection with any loan made by the 
credit union. The Board believes that this structure will be easier to 
interpret and administer. It has proved difficult to determine, in the 
current regulation, whether certain activities are part of 
``underwriting, insuring, servicing, or collecting'' a loan, 
particularly ``underwriting'' and ``insuring.'' Proposed paragraph 8(i) 
only requires that an activity be determined to be ``in connection 
with'' a loan. NCUA would take a reasonableness approach to that 
determination.
    For example, suppose an official owns a company that manufactures 
forms. In this example, a credit union could purchase loan application 
forms from the company, even if it resulted in compensation to the 
official, since the purchase of loan application forms is not 
reasonably ``in connection with'' making a loan.\1\ On the other hand, 
if an official owned a credit bureau, a credit union could not obtain 
credit reports from the company, resulting in compensation to the 
official, because providing credit reports is reasonably ``in 
connection with'' making a loan.

    \1\Other legal restrictions would apply, however. For example, 
common law principles would require that the transaction be at arms 
length and in the credit union's best interest, and the standard FCU 
Bylaws would require that the interested director recuse himself or 
herself from the decision to purchase the forms.
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    Similarly, a credit union could finance a home built by a 
construction company owned by an official, as long as the credit union 
was not financing the construction of the home, as building a home is 
not reasonably in connection with making a loan. However, a credit 
union would be prohibited from referring a member to the construction 
company to have a home built, as in that case, the construction would 
be in connection with making a loan.
    In the context of incentive pay, rather than outside compensation, 
loan processing and making credit decisions on loans are clearly 
activities in connection with making loans. Thus, an employee would be 
prohibited from receiving incentive pay for performing those activities 
unless covered by an exception.
    Exception (A) would allow credit unions to pay salary to employees 
who perform activities in connection with making loans. This is in the 
current regulation and needs no discussion.
    Exception (B) would clarify that an incentive may be paid to an 
employee based on the overall financial performance of the credit 
union, which of course depends in part on its lending activities. While 
it could be argued that such an incentive is not truly ``in connection 
with'' a loan made by the credit union, the Board has included the 
exemption to avoid confusion. The Board believes that this type of 
incentive presents fewer problems than does an incentive based on the 
performance of a single individual, as it is focused on the interests 
of the credit union as a whole. However, incentives based on an 
organization's overall performance must still be monitored closely to 
avoid the problems discussed above. NCUA of course reserves the right 
to take exception to overall performance related incentive plans for 
safety and soundness reasons, for example, and plans where incentive 
pay is based on asset growth with no consideration of factors such as 
capital and asset quality.
    Despite the concerns raised about incentives based on an 
individual's performance, the Board is proposing to allow credit unions 
to develop incentive programs with that feature. The Board is 
responsive to the significant interest on the part of credit unions to 
implement such programs. Proposed exceptions (C), (D), and (E) would 
allow credit unions to make incentive payments to employees for 
processing loans, making recommended or final decisions to approve or 
disapprove loans, and collecting loans, respectively. In order for an 
employee to be eligible for an incentive, there must be a supervisory 
level above the employee that does not receive incentive pay for the 
activity in question. Furthermore, a senior management employee may not 
receive incentive pay for any of the activities. Supervisors and senior 
management employees are excluded from direct incentive pay in the 
interests of sound internal control. However, the proposed rule would 
allow such employees to receive bonuses based on broad measures of 
management skill, such as profitability.
    Credit unions already have the authority to provide incentive pay 
for processing and collecting loans. The real change is the proposal to 
allow loan officers to receive incentive pay. To address the concern 
regarding loan quality, the proposed rule provides that incentives for 
making recommended or final decisions to approve or disapprove loans 
may not be based on the number or dollar amount of loans approved. The 
Board requests comment on this restriction. Commenters who believe that 
it is not necessary should provide evidence to that effect.
    The proposed rule also requires that there be sufficient controls 
in place to prevent an increase in problem loans. A credit union would 
have the responsibility of structuring its incentive pay program to 
meet this requirement.
    Finally, proposed paragraph (8)(iv) of the regulation would require 
that the board of directors establish written policies and controls for 
any incentive plan and monitor compliance on at least a quarterly 
basis. [[Page 19692]] 

Policy Changes

    In addition to allowing incentive pay for loan officers under 
certain circumstances, the proposed rule would make additional policy 
changes. The current regulation has been interpreted to permit a credit 
union official or employee to receive compensation for acting as an 
agent in the sale of property securing a loan made by a credit union, 
on the rationale that listing or selling a property on which a loan is 
granted is not included in underwriting, insuring, servicing, or 
collecting the loan. Under this interpretation, an official or employee 
not only could receive a commission from an outside party for selling 
property financed by the credit union, he or she could also act as 
listing agent for the credit union's sale of foreclosed properties 
financed by the credit union. While listing or selling property 
financed by a credit union is not included in underwriting, insuring, 
etc., it is reasonably ``in connection with'' a loan made by the credit 
union. Thus, compensation for such activity would be prohibited unless 
the activity is covered by an exception. Since compensating an official 
or employee for listing or selling property financed by the credit 
union presents potential conflicts of interest, no exception is 
provided.
    The current regulation also permits employees who are not senior 
managers or loan officers to receive incentives, from either the credit 
union or an insurance company, for selling credit life and disability 
insurance. Senior managers and loan officers may not receive such 
incentives because of the prohibition against compensation for 
``insuring'' a loan. Since selling credit insurance is an activity 
reasonably ``in connection with'' a loan, the proposed rule prohibits 
all employees from receiving compensation for the activity, unless it 
is covered by an exception. The Board believes members should be 
allowed to make their own informed decisions about credit insurance and 
should not be pressured into purchasing it by employees who are 
motivated by incentive pay. Accordingly, no exception is provided. Lest 
there be any misunderstanding, however, credit unions are allowed to 
sell credit insurance and to generate income for the credit union from 
the activity.
    The proposed regulation also clarifies another issue related to 
insuring loans. The current regulation has always been interpreted to 
prohibit, for example, a credit union official from owning an insurance 
company that sells car insurance to members who finance their cars at 
the credit union. Recently, it has been argued that the regulatory 
language prohibits compensation in connection with insuring the loan 
but not in connection with insuring collateral securing the loan. Under 
this argument, the regulation clearly would apply to credit life and 
disability insurance but would not appear to apply to ordinary car or 
homeowners insurance. NCUA is concerned about the inherent conflict 
that arises if an owner of an insurance agency that insures collateral 
securing loans made by a credit union serves as a credit union 
official, because of the opportunity to ``steer'' members to the 
official's agency. Since insuring collateral is reasonably ``in 
connection with'' a loan, the proposed regulation continues the 
prohibition against a director receiving compensation for such 
activity.
    The Board also notes that ``insuring the loan'' recently has been 
interpreted to include the sale of vehicle warranties (also called 
insured vehicle service contracts and mechanical breakdown insurance) 
in states in which such products are considered insurance. Thus, credit 
union employees have been prohibited from receiving incentive pay for 
selling vehicle warranties in those states. Since such products 
generally are sold at the time a loan is made, they are reasonably ``in 
connection with'' a loan. Therefore, the proposed regulation would 
prohibit the payment of incentives to employees for the sale of these 
products, regardless of whether they are considered insurance in a 
particular state.

Regulatory Procedures

Regulatory Flexibility Act

    The NCUA Board certifies that this final rule will not have a 
significant impact on a substantial number of small credit unions 
(those under $1 million in assets). Accordingly, a Regulatory 
Flexibility Analysis is not required.

Paperwork Reduction Act

    This proposed rule, if adopted, will impose no additional 
collection requirements and, therefore, need not be sent to the Office 
of Management and Budget for approval.

Executive Order 12612 -

    Executive Order 12612 requires NCUA to consider the effect of its 
actions on state interests. It states that: ``Federal action limiting 
the policy-making discretion of the states should be taken only where 
constitutional authority for the action is clear and certain, and the 
national activity is necessitated by the presence of a problem of 
national scope.'' The risks to federally insured credit unions are 
concerns of national scope. The NCUA Board believes that the protection 
of the NCUSIF warrants this rule. It will not unduly burden federally 
insured state-chartered credit unions. This rule does not impose 
additional costs or burdens on the state, nor does it affect the 
states' ability to discharge traditional state government functions. -
    The benefits provided and protection afforded by the NCUSIF are the 
same for federally insured state-chartered credit unions as for 
federally chartered credit unions. It is protection afforded through a 
federal system. The responsibility for administering that system lies 
with the NCUA Board. The NCUA Board believes that all federally insured 
credit unions should continue to be subject to the same conflict 
provisions in the area of lending. The NCUA Board, pursuant to 
Executive Order 12612, has determined that this rule may have an 
occasional direct effect on the states, on the relationship between the 
national government and the states, or on the distribution of power and 
responsibilities among the various levels of government. However, the 
potential risk to the NCUSIF without these changes justifies them.

List of Subjects in 12 CFR Part 701

    Credit unions.

    By the National Credit Union Administration Board on April 13, 
1995.
Becky Baker,
Secretary of the Board.

    For the reasons set forth in the preamble, NCUA proposes to amend 
12 CFR part 701 as follows:

PART 701--ORGANIZATION AND OPERATION OF FEDERAL CREDIT UNIONS

    1. The authority citation for part 701 continues to read as 
follows:

    Authority: 12 USC 1752(5), 1755, 1756, 1757, 1759, 1761a, 1761b, 
1766, 1767, 1782, 1784, 1787, 1789, and Public Law 101-73. Section 
701.6 is also authorized by 31 USC 3717. Section 701.31 is also 
authorized by 15 USC 1601, et seq., 42 USC 1981, and 42 USC 3601-
3610. Section 701.35 is also authorized by 12 USC 4311-4312.

    2. Section 701.21(c)(8) is revised to read as follows:


Sec. 701.21  Loans to members and lines of credit to members.

* * * * *
    (c) * * *
    (8) Prohibited fees; exceptions.
    (i) Except as otherwise provided in this section, no official or 
employee of a Federal credit union, or immediate family member of an 
official or [[Page 19693]] employee of a Federal credit union, may 
receive, directly or indirectly, from an outside party or the credit 
union, any commission, fee, or other compensation in connection with 
any loan made by the credit union.
    (ii) For the purposes of this section:
    (A) Compensation includes non monetary items.
    (B) Employee includes an independent contractor.
    (C) Immediate family member means a spouse or other family member 
living in the same household.
    (D) Loan includes line of credit and workout loan.
    (E) Official means any member of the board of directors or a 
volunteer committee.
    (F) Senior management employee means the credit union's chief 
executive officer (typically, this individual holds the title of 
President or Treasurer/Manager), any assistant chief executive officers 
(e.g., Assistant President, Vice President, or Assistant Treasurer/
Manager), the chief financial officer (Comptroller), and any other 
employee who sets policy for the credit union.
    (G) Workout loan means a loan which has had its original terms 
changed due to nonperformance or anticipated nonperformance.
    (iii) This section does not prohibit a Federal credit union from 
paying:
    (A) Salary to employees; - -
    (B) An incentive or bonus to an employee based on the credit 
union's overall financial performance;
    (C) An incentive or bonus to an employee in connection with 
processing loans, provided that no such incentive or bonus is paid to a 
supervisor of the employee, a senior management employee, or an 
immediate family member of a supervisor or senior management employee;
    (D) An incentive or bonus to an employee in connection with making 
recommended or final decisions to approve or disapprove loans, provided 
that:
    (1) No such incentive or bonus is paid to a supervisor of the 
employee, a senior management employee, or an immediate family member 
of a supervisor or senior management employee; and
    (2) The incentive or bonus may not be based on the number or dollar 
amount of loans approved and must be structured in a manner that 
demonstrably protects against an increase in problem loans;
    (E) An incentive or bonus to an employee in connection with 
collecting loans, provided that no such incentive or bonus is paid to a 
supervisor of the employee, a senior management employee, or an 
immediate family member of a supervisor or senior management employee.
    (iv) The board of directors of a Federal credit union shall 
establish and implement written policies, procedures, and internal 
controls for any payment of incentives or bonuses to employees in 
connection with loans made by the credit union. At least quarterly, the 
board shall monitor compliance with such policies, procedures, and 
controls. Documentation of such monitoring shall be made available to 
the supervisory committee and NCUA.
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[FR Doc. 95-9616 Filed 4-19-95; 8:45 am]
BILLING CODE 7535-01-U