Final Rule Summary

Prepared by NASCUS Legislative & Regulatory Affairs Department
March 2016

NCUA 12 CFR Part 723

Member Business Loans; Commercial Lending

NCUA published a final rule intended to modernize its member business loans (MBL) rule to provide federally insured credit unions with greater flexibility and autonomy to provide commercial and business loans to their members.  The final rule amends the current regulatory requirements pertaining to credit union commercial lending activities by replacing the current “prescriptive requirements” (such as collateral and security requirements, equity requirements, and loan limits) with a broad “principles-based” regulatory approach.  As detailed in the proposal, the final rule eliminates most of the regulatory thresholds and limits in Part 723 and replaces those provisions with expanded requirements pertaining to policies, procedures and oversight by credit union management and credit union directors.

Provisions 701.22, 723.1, 723.2, 723.4, 723.5(a), 723.8, 723.9 and 741.203 of the rule become effective on January 1, 2017.  Section 723.5(b) (“Personal Guarantees”) becomes effective 60 days after the final rule’s publication in the Federal Register. 

You can access the final rule here.

Summary

Prescriptive to Principles-based approach

According to NCUA, the final rule represents a shift in the agency’s regulatory approach and supervisory expectations.  Under the final rule, the previous prescriptive requirements (collateral and security requirements, equity requirements, loans limits and MBL waiver process) have been replaced with broad principles intended to permit credit unions to “govern safe and sound commercial lending.”  Under the new principles, NCUA expects credit union will maintain prudent risk management practices and sufficient capital commensurate with the risk associated with their commercial lending activities. 

NCUA’s oversight will focus on the effectiveness of the credit union’s risk management process and the aggregate risk profile of the credit union’s loan portfolio as opposed to the credit union’s compliance with prescriptive measures.

MBL Guidance and delayed implementation

NCUA will issue Supervisory guidance before the final rule takes effect. 
NCUA‘s guidance and future examiner training will focus on:

  • Overarching principles for managing commercial loan risk;
  • Critical components of commercial loan policies;
  • The credit approval process;
  • Credit risk-rating systems;
  • Structuring of credit packages to properly align members’ needs with financial abilities to repay; and
  • Credit risk management processes for underwriting, ongoing loan administration and risk monitoring.

Exemption for Small Credit Unions

The final rule retains the small credit union exemption that permits credit unions (i) with assets less than $250 million and (ii) total commercial loans less than 15% of net worth that are not regularly originating and selling or participating out commercial loans to be exempted from § 723.3 and § 723.4.

Purpose and Scope, § 723.1

This section sets out policy and program responsibilities that a FICU must adopt and implement as part of a safe and sound commercial lending program, and incorporates the statutory limit on the aggregate amount of member business loans that a FICU may make pursuant to Section 107A of the Federal Credit Union Act.

The following are exempted from the commercial loan/MBL rules:

  • Made by a corporate credit union
  • Made by a FICU to another FICU
  • Made by a FICU to a CUSO
  • Fully secured by a lien on a 1-to-4-family residential property that is a member’s primary residence

Other regulations that apply, §723.1(c)

This section clarifies that the following:

  • FISCUs must comply with § 701.21(c)(8) concerning prohibited fees and § 701.21(d)(5) concerning non-preferential loans. 
  • If a FCU makes a commercial loan through a program in which a federal or state agency (or its political subdivision) insures repayment, guarantees repayment, or provides an advance commitment to purchase the loan in full, and that program has requirements that are less restrictive than those required by this rule, then the FCU may follow the loan requirements of the relevant guaranteed loan program.  A FISCU that is subject to this part and that makes a commercial loan as part of a loan program in which a federal or state agency (or its political subdivision) insures repayment, guarantees repayment or provides an advance commitment to purchase the loan in full, and that program has requirements that are less restrictive than those required by this rule, then the FISCU may follow the loan requirements of the relevant guaranteed loan program, provided that its state supervisory authority has determined that it has authority to do so under the law.
  • The requirements of § 701.23 applies to a FCU’s purchase, sale or pledge of commercial loan as eligible obligation.
  • The requirements of § 701.22 applies to a FICU’s purchase of a participation interest in a commercial loan.

Definitions, §723.2

Under the final rule, the following definitions apply:

Associated borrower means any other person or entity with a shared ownership, investment, or other pecuniary interest in a business or commercial endeavor with the borrower. This means any person or entity named as a borrower or debtor in a loan or extension of credit, or any other person or entity, such as a drawer, endorser, or guarantor, engaged in a common enterprise with the borrower, or deriving a direct benefit from the loan to the borrower.  Note: the term “associated borrower” has replaced the term “associated member.” The associated borrower definition in NCUA’s loan participation rule would also be amended in a parallel manner.

Exceptions to this definition for partnerships, join ventures and associations are as follows:

  • If the borrower is a partnership, joint venture or association, and the other person with a shared ownership, investment, or other pecuniary interest in a business or commercial endeavor with the borrower is a member or partner of the borrower, and neither a direct benefit nor a common enterprise exists, such other person is not an associated borrower.
  • If the borrower is a member or partner of a partnership, joint venture or association and the other entity with a shared ownership, investment, or other pecuniary interest in a business or commercial endeavor with the borrower is the partnership, joint venture, or association and the borrower is a limited partner of that other entity, and by the terms of a partnership or membership agreement valid under applicable law, the borrower is not held generally liable for the debts or actions of that other entity, such other entity is not an associated borrower.
  • If the borrower is a member or partner of a partnership, joint venture, or association and the other person with a shared ownership, investment, or other pecuniary interest in a business or commercial endeavor with the borrower is another member or partner of the partnership, joint venture or association and neither a direct benefit nor a common enterprise exists, such other person is not an associated borrower.

Commercial loan means any loan, line of credit, or letter of credit (including any unfunded commitments) and any interest a credit union obtains in such loans made by another lender, to individuals, sole proprietorships, partnerships, corporations, or other business enterprises for commercial, industrial, agricultural, and professional purposes but not for personal expenditure purposes. The final rule provides the following exceptions:

  • loans made by a corporate credit union
  • loans made by a FICU to another FICU
  • loans made by a federally insured credit union to a CUSO
  • loans secured by a 1-4 family residential property (whether or not it is the borrower’s primary residence)
  • loans secured by a vehicle manufactured for household use
  • any loan fully secured by shares in the credit union making the extension of credit or deposits in other financial institutions
  • any loan(s) that would otherwise meet the definition of commercial loan and which, when the aggregate outstanding balances plus unfunded commitments less any portion secured by shares in the credit union to a borrower or an associated borrower, are equal to less than $50,000.

 Note: loans for the purchase of fleet vehicles or to purchase a vehicle to carry fare-paying passengers are commercial loans, as are loans to a vehicle dealership or seller to replenish its regular inventory of vehicles for sale.

Common enterprise exists when:

  • the expected source of repayment for each loan or extension of credit is the same for each borrower and no individual borrower has another source of income from which the loan (together with the borrower’s other obligations) may be fully repaid
  • the loans are extensions of credit made to borrowers who are related directly or indirectly through common control (including where one borrower is directly or indirectly controlled by another borrower) and substantial financial interdependence exists between or among the borrowers
  • the separate borrowers obtain loans or extensions of credit to acquire a business enterprise of which those borrowers will own more than 50% of the voting securities or voting interests

Control means a person or entity directly or indirectly, or acting through or together with one or more persons or entities that:

  • own, control, or have the power to vote 25% or more of any class of voting securities of another person or entity
  • control, in any manner, the election of a majority of the directors, trustees, or other persons exercising similar functions of another person or entity
  • have the power to exercise a controlling influence over the management or policies of another person or entity

Credit risk rating system means a formal process that identifies and assigns a relative credit risk score to each commercial loan in a FICU’s portfolio, using ordinal ratings to represent the degree of risk.  The credit risk score is determined through an evaluation of quantitative factors based on financial performance and qualitative factors based on management, operational, market, and business environmental factors.  

Direct benefit means the proceeds of a loan or extension of credit to a borrower, or assets purchased with those proceeds, that are transferred to another person or entity, other than in a bona fide arm’s length transaction where the proceeds are used to acquire property, goods, or services.

Immediate family member means a spouse or other family member living in the same household.

Loan secured by a 1-4 family residential property means any loan secured (at origination) wholly or substantively by a lien on a 1- 4 family residential property for which the lien is central to the extension of credit. A loan is wholly or substantially secured by a lien on a 1-to-4 family residential property if the estimated value of the real estate collateral at origination (after deducting any senior liens held by others) is greater than 50 %of the principal amount of the loan.

 Loan secured by a vehicle manufactured for household use means a loan that (at origination) is secured wholly or substantially by a lien on a new and used passenger cars and other vehicles such as minivans, sport-utility vehicles, pickup trucks, and similar light trucks or heavy duty trucks generally manufactured for personal, family, or household use and not used as fleet vehicles or to carry fare-paying passengers.  A loan is wholly or substantially secured by a lien on a vehicle manufactured for household use if the estimated value of the collateral at origination (after deducting any senior liens held by others) is greater than 50% of the principal amount of the loan.

Loan-to-value ratio (LTV) means, with respect to any item of collateral, the aggregate amount of all sums borrowed and secured by that collateral, including outstanding balances plus any unfunded commitment or line of credit from another lender that is senior to the FICU’s lien position, divided by the current collateral value.  The current collateral value must be established by prudent and accepted commercial lending practices and comply with all regulatory requirements.  For a construction and development loan, the collateral value is the lesser of cost to complete or prospective market value, as determined in accordance with § 723.6.

Net worth means a FICU’s net worth as defined in NCUA’s part 702. 

Readily marketable collateral means a financial instrument or bullion that is salable under ordinary market conditions with reasonable promptness at a fair market value determined by quotations based upon actual transactions on an auction or similarly available daily bid and ask price market.

Residential property means a house, condominium, cooperative unit, manufactured home, and unimproved land zoned for 1- to 4- family residential use. A boat or motor home, even if used as a primary residence or timeshare property is not residential property.

Board of Directors and Management Responsibilities, § 723.3

Requires the Board of a FICU to (at a minimum):

  • Approve the credit union’s commercial loan policy
  • Review the policy on an annual basis, prior to any material change in the FICU’s commercial lending program or related organizational structure, and in response to any material change in the FICU’s portfolio performance or economic conditions
  • Ensure the FICU appropriately staffs its commercial lending program

Required Expertise and Experience: FICUs making, purchasing, or holding any commercial loan must ensure that staff has the following experience and competencies:

  • The FICU’s senior executive officers overseeing the commercial lending function must understand the FICU’s commercial lending activities.  At a minimum, senior executive officers must have a comprehensive understanding of the role of commercial lending in the FICU’s overall business model and establish risk management processes and controls necessary to safely conduct commercial lending.
  • The FICU must employ qualified lending staff with expertise in underwriting and processing for the type(s) of commercial lending in which the FICU is engaged; overseeing and evaluating the performance of a commercial loan portfolio, including rating and quantifying risk through a credit risk rating system; and conducting collection and loss mitigation activities for the type(s) of commercial lending in which the FICU is engaged.

An FICU may meet the experience requirements by conducting internal training and development, hiring qualified individuals, or using a third-party, such as an independent contractor or credit union service organization.

However, use of a third-party is permitted only if the following conditions are met:

  • The third party has no affiliation or contractual relationship with the borrower or any associated borrowers;
  • The actual decision to grant a loan must reside with the FICU;
  • Qualified FICU staff exercises ongoing oversight over the third party by regularly evaluating the quality of any work the third party performs for the FICU; and
  • The third party arrangement must comply with Section 723.7.

Commercial Loan Policy, §723.4

This section is comparable to existing §723.6, and requires a commercial loan policy address the following:

  • Types of commercial loans permitted
  • Trade area
  • Maximum amount of assets, in relation to net worth, that the credit union will lend to any one borrower or group of associated borrowers, in aggregate, across all categories, including secured, unsecured, and unguaranteed loans Note: the proposed rule requires credit unions to include a cap in their policies limiting commercial loans to one borrower, or group of associated borrowers to an aggregate amount not to exceed 15% of the credit union’s net worth, or $100k (whichever is greater) plus an additional 10% of the FICU’s net worth if the amount that exceeds the 15% cap is fully secured at all times with a perfected security interest by readily marketable collateral as defined in proposed §723.2.   Any insured or guaranteed portion of a commercial loan made through a program in which a federal or state agency (or its political subdivision) insures repayment, guarantees repayment or provides an advance commitment to purchase the loan in full, is excluded from this limit
  • The qualifications and experience requirements of personnel involved in the administration of the commercial loan program
  • The loan approval process, including levels of approval authority commensurate with the loans complexity and risk to the credit union
  • Underwriting standards, commensurate with the size, scope and complexity of the commercial lending activities and borrowing relationships contemplated.  The standards must (at minimum) address the scope of financial analysis necessary to evaluate the borrower and borrower’s ability to repay, due diligence of the principles and any impact principles might have on borrower’s ability to meet repayment terms, requirements for borrower projections when historic performance does not support repayment projections, requirements for financial statements sufficient to support accurate analysis and risk assessment, guidelines for evaluating collateral, including loan-to-value limits and means to secure collateral, and all other appropriate risk assessments such as analysis of current market conditions
  • Formal risk management processes commensurate with the size, scope and complexity of commercial lending activities, including (as appropriate) the use of covenants, the frequency of borrower financial reporting, periodic loan reviews, use of a credit risk rating system; and
  • A process to identify, report and monitor loans approved as exceptions to the general policies

Collateral and Security, § 723.5

The final rule requires security and collateral as follows:

  • CUs  must require collateral commensurate with loan’s  level of risk  and sufficient to ensure adequate  balance protection and risk sharing with the borrower
  • Unsecured commercial loans must contain documentation in the loan file that reflects mitigating factors sufficient to offset the risk
  • A loan made to a borrower without a personal must contain loan file documentation reflecting mitigating factors sufficient to offset the risk 

Construction and Development Loans, § 723.6

 A construction and development loan is defined as any financing arrangement to enable the borrower to acquire property or rights to property, including land or structures, with the intent to construct or renovate an income producing property, such as residential housing for rental or sale, or a commercial building, such as may be used for commercial, agricultural, industrial, or other similar purposes. It also means a financing arrangement for the construction, major expansion or renovation of the preceding property types. A loan to finance the maintenance, repairs, or improvements to an existing income producing property that does not change its use or materially impact the property is not a construction or development loan. An FICU that elects to make a construction or development loan must ensure that its commercial loan policy includes adequate provisions by which the collateral value associated with the project is properly determined and established.

The final rule establishes the collateral value of a construction or development loan as the lesser of the project’s cost to complete or its prospective market value.

  • Cost to complete means the cost to complete as the sum of all qualifying costs necessary to complete a construction project and documented in an approved construction budget. The “qualifying costs” would include on/off-site improvements, building construction, and other reasonable and customary costs such as general contractor's fees, bonding, and contractor insurance. Qualifying costs also include the value of the land (determined as the lesser of appraised market value or purchase price for land held less than 12 months, or the appraised market value for land held longer than 12 months).  Qualifying costs also include interest, a contingency account to fund unanticipated overruns, and other development costs such as fees and related pre-development expenses.  Interest expense is a qualifying costs only to the extent it is included in the construction budget and is calculated based on the projected changes in the loan balance up to the expected “as complete” date for owner-occupied non-income producing commercial real estate or the “as stabilized” date for income producing real estate. Project costs for related parties, such as developer fees, leasing expenses, brokerage commissions, and management fees, may be included only if reasonable in comparison to the cost of similar services from a third party. Qualifying costs do not include interest or preferred returns payable to equity partners or subordinated debt holders, the developer's general corporate overhead, and selling costs to be funded out of sales proceeds such as brokerage commissions and other closing costs.
  • Prospective market value means the market value opinion determined by an independent appraiser in compliance with the Uniform Standards of Professional Appraisal Practice (Statement 4). Depending on whether the property is held for commercial use or for income producing use, one of two valuation methods may be sued. The prospective market value “as-completed” reflects the property's market value as of the time that development is to be completed and begin commercial use. The prospective market value “as-stabilized” reflects the property's market value as of the time an income producing property is projected to achieve stabilized occupancy.

CUs engaged in construction and development lending must also include the following in their loan polices:

  • qualified CU personnel must review and approve a line item construction budget prior to closing the loan
  • a CU approved requisition and loan disbursement process
  • requirement that funds are released or dispersed only after on-site inspections performed by a qualified individual representing the CU. The inspection must certify in writing  that the work requisitioned for payment has been completed and the remaining line of credit    is sufficient to complete the project
  • confirm absence of any intervening liens before dispersing any funds

 Prohibited Activities, § 723.7

The rule prohibits an FICU from granting a commercial loan in the following cases:

  • Any senior management employee directly or indirectly involved in the CU’s commercial loan underwriting, servicing, and collection process, and any of their immediate family members or associated borrowers of those senior staff and family, or any compensated director, unless the FICU’s board approves the loan (with the compensated director recused).

When any additional income received by the FICU or its senior management employees is tied to the profit or sale of any business or commercial endeavor that benefits from the proceeds of the loan.

In addition, the conflict of interest provision prohibits any third party used to satisfy the expertise requirements from having a participation interest in the loan or any interest in collateral securing a loan being evaluated by the third party. Third parties are also prohibited from receiving compensation contingent on the closing of a loan, with the following exceptions: the third party may 1) provide services related to the loan such as loan servicing; 2) purchase a participation interest in a loan it evaluates for a credit union; and 3) a CUSO need not be independent from the transaction provided the credit union has a controlling financial interest in the CUSO.

Aggregate Member Business Loan Limit; exclusions and exceptions, § 723.8

The final rule incorporates the statutory limits on the aggregate amount of member business loans that may be held by an FICU of the lesser of 1.75 times the actual net worth of the credit union or 1.75 times the minimum net worth by the PCA to be well capitalized. The final rule omits the reference to 12.25% of assets.

Part 723.8 defines member business loans to mean any commercial loan defined in Section 723.2 except for the following:

  • Any loan in which a federal or state agency (or its political subdivision) fully insures repayment, fully guarantees repayment or provides an advance commitment to purchase the loan in full; and
  • Any non-member commercial loan or non-member participation interest in a commercial loan made by another lender, provided the FICU acquired the non-member loans and participation interests in compliance with all relevant laws and regulations and it is not, trying to evade the cap

Two types of MBLs are excluded from the definition of commercial loan and but are MBLs for purpose of calculating the 1.75% cap: (if the outstanding aggregate member business loan balance is greater than $50,000):

  • Any loan secured by a 1 to 4 family residential property that is not a member’s primary residence, and
  • Any loan secured by a vehicle manufactured for household use that will be used for commercial, corporate or other business investment property or venture, or agricultural purpose.

Pursuant to the statute and the rule, the following CUs are exempt from the MBL 1.75% cap:

  • Credit unions with an LICU designation
  • Credit unions that participate in the Community Development Financial Institutions program
  • Credit unions chartered for the purpose of making commercial loans
  • Credit unions that had a history of primarily making member business loans as of the date of enactment of the Credit Union Membership Access Act of 1988 (CUMAA)

Under the final rule, calculation of net member business loan balance is the same as existing Part 723.  For the purposes of NCUA form 5300 reporting, an FICU’s net member business loan balance is determined by calculating the outstanding loan balance plus any unfunded commitments, reduced by any portion of the loan that is secured by shares in the credit union, or by shares or deposits in other financial institutions, or by a lien on the member’s primary residence, or insured or guaranteed by any agency of the federal government, a state or any political subdivision of such state, or subject to an advance commitment to purchase by any agency of the federal government, a state or any political subdivision of such state, or sold as a participation interest without recourse and qualifying for true sales accounting under generally accepted accounting principles.

Under the final rule, any waiver previously issued by NCUA concerning any aspect of the current rule becomes moot upon the final rule’s effective date, except waivers that were granted for borrowing relationships to exceed the limits set forth in existing §723.8.  Borrowing relationships granted a waiver from that provision will be grandfathered, however, the debt associated with those relationships may not be increased.

Any enforcement actions or other constraints imposed on an FICU (in connection with its commercial lending program) remain in effect.

State Regulation of Business Lending, § 723.10

The final rule states that FICUs in a given state are exempted from compliance with this part if the state supervisory authority administers a state commercial and member business loan rule for use by FISCU in that state, provided the state rule at least covers all the provisions in this part and is no less restrictive (based on NCUA’s determination).

States that currently have exemptions from NCUA’s MBL rule are grandfathered in under the final rule. Any modification to those t rules must be consistent with NCUA’s MBL rule.  However, modification of one part of an existing NCUA approved state rule will not cause other parts of the rule to lose their grandfathered status. 

Loan Participation, § 701.22

The final rule sets forth the following definitions:

Associated Borrower: any other person or entity with a shared ownership investment, or other pecuniary interest in a business or commercial endeavor with the borrower.  This means any person or entity named as a borrower or debtor in a loan or extension of credit, or any other person or entity, such as a drawer, endorser, or guarantor, engaged in a common enterprise with the borrower, or deriving a direct benefit from the loan borrower.

Exceptions to this definition for partnerships, join ventures and associations are as follows:

  • If the borrower is a partnership, joint venture or association, and the other person with a shared ownership, investment, or other pecuniary interest in a business or commercial endeavor with the borrower is a member or partner of the borrower, and neither a direct benefit nor a common enterprise exists, such other person is not an associated borrower.
  • If the borrower is a member or partner of a partnership, joint venture or association and the other entity with a shared ownership, investment, or other pecuniary interest in a business or commercial endeavor with the borrower is the partnership, joint venture, or association and the borrower is a limited partner of that other entity, and by the terms of a partnership or membership agreement valid under applicable law, the borrower is not held generally liable for the debts or actions of that other entity, such other entity is not an associated borrower.
  • If the borrower is a member or partner of a partnership, joint venture, or association and the other person with a shared ownership, investment, or other pecuniary interest in a business or commercial endeavor with the borrower is another member or partner of the partnership, joint venture or association and neither a direct benefit nor a common enterprise exists, such other person is not an associated borrower.

Common enterprise exists when:

  • the expected source of repayment for each loan or extension of credit is the same for each borrower and no individual borrower has another source of income from which the loan (together with the borrower’s other obligations) may be fully repaid. 
  • the loans are extensions of credit made to borrowers who are related directly or indirectly through common control (including where one borrower is directly or indirectly controlled by another borrower) and substantial financial interdependence exists between or among the borrowers.
  • the separate borrowers obtain loans or extensions of credit to acquire a business enterprise of which those borrowers will own more than 50% of the voting securities or voting interests

 Control means a person or entity directly or indirectly, or acting through or together with one or more persons or entities that:

  • owns, controls, or has the power to vote 25% or more of any class of voting securities of another person or entity
  • controls, in any manner, the election of a majority of the directors, trustees, or other persons exercising similar functions of another person or entity
  • has the power to exercise a controlling influence over the management or policies of another person or entity

Direct benefit means the proceeds of a loan or extension of credit to a borrower, or assets purchased with those proceeds, that are transferred to another person or entity, other than in a bona fide arm’s length transaction where the proceeds are used to acquire property, goods, or services.

Minimum Loan Policy Requirements, § 741.203

Requires FISCUs to comply with requirements under Part 723 concerning commercial and member business loans; § 701.21(c)(8) concerning prohibited fees and § 701.21(d)(5) concerning non-preferential loans.

Provides for FISCUs to be exempt from these requirements if the state supervisory authority adopts substantially equivalent regulations as determined by the NCUA Board or, in the case of the commercial lending and member business loan requirements, if the state supervisory authority administers a state commercial and member business loan rule for use by FISCUs chartered in that state that at least covers all the provisions of Part 723 and is no less restrictive (based on NCUA’s determination).  In nonexempt states, all required NCUA reviews and approvals will be handled in coordination with the state credit union supervisory authority.