We are concerned about our legal lending limit. One of our loan customers is a contractor. The contractor has been hired by some of our other loan customers for real estate development projects, and the contractor has provided guarantees to us for each project (referred to in our documents as “Guaranty of Completion and Payment”). Do we have to count the customer’s guarantees towards our lending limit, even though each one guarantees a different customer’s loan?

Overview

Whether you will be required to aggregate the contractor’s guarantees with your institution’s loans to the contractor depends on several factors, and we recommend analyzing the guarantees under three different tests, from the Illinois Banking Act, the Illinois Department of Financial and Professional Regulation (IDFPR) regulations, and the OCC regulations (which the IDFPR recommends, even though your institution is not regulated by the OCC). While we cannot provide legal advice to your institution and do not have enough facts to apply each test, our guidance on the three tests is below.

Also, we discussed these issues with an attorney from your primary regulator, the IDFPR, who confirmed that financial institutions should consider all three of these tests when analyzing a lending limit issue. Further, the IDFPR recommends scrutinizing the ownership of the different entities that are providing guarantees and taking loans from your institution, to ensure that each entity has sufficient cash flow to support each loan or guarantee. Overall, IDFPR examiners will be looking at your loan documentation for each loan and guarantee for any sign that your institution has “usurped” your lending limits.

First Test: Illinois Banking Act

The Illinois Banking Act limits the total liability of one person to the bank. Section 32 of the Act states that any one person’s liability to a bank for “money borrowed” cannot exceed 25% of the bank’s unimpaired capital and unimpaired surplus. 205 ILCS 5/32. However, separate limits apply to the guarantees provided to a bank by any one person. As outlined in IDFPR Interpretive Letter 93-13 (July 30, 1993), there are three possible limits that could apply under the Illinois Banking Act.

25% Lending Limit: The lending limit, which applies to “money borrowed.” This category cannot exceed 25% of a bank’s unimpaired capital and unimpaired surplus. 205 ILCS 5/32.
25% Guarantee Limit: A separate limit on guarantors of payment, which applies to guarantees made by a single guarantor that qualify as guarantees “of payment,” rather than guarantees “of collection.” This category cannot exceed 25% of a bank’s unimpaired capital and unimpaired surplus. 205 ILCS 5/32(5).
50% Aggregated Limit: A separate limit on all liabilities, including all loans to and guarantees provided by a single customer. This category cannot exceed 25% of a bank’s total deposits or 50% of a bank’s unimpaired capital and unimpaired surplus. 205 ILCS 5/32.

(Note that the IDFPR letter was written in 1993, when the lending limit was set at 20%. The Illinois Banking Act has since been amended to move the lending limit up to 25%, but it otherwise has not changed. Therefore, we continue to rely on the 1993 IDFPR letter for guidance. Also note that Illinois banks, if acting in “good faith,” cannot be held liable for taking an action or omitting to act based on an IDFPR rule, interpretation, or opinion. 205 ILCS 5/48.5.)

To determine whether the 25% guarantee limit or the 50% aggregate limit applies, you will have to determine whether the guarantees at issue are guarantees “of payment” or guarantees “of collection.” The 1993 IDFPR Interpretive Letter discussed above defines both terms, using definitions from the Uniform Commercial Code (UCC):

Guarantee of Payment: The IDFPR letter relies on the UCC’s definition of “guarantee of payment,” though this definition had been eliminated in 1992. Under the UCC definition, a guarantee of payment “meant that the guarantor would pay the instrument when due without resort by the holder to any other party.”

Guarantees of payment provided by a single guarantor are subject to the 25% guarantee limit discussed above. However, that 25% limit should be calculated without including the amounts of loans provided by your institution to the guarantor.

Guarantee of Collection: Subsection 3-419(d) of the UCC defines as guarantee of collection as one where the guarantor “unambiguously” states that it is “guaranteeing collection rather than payment,” and the guarantor agrees to pay only after you have unsuccessfully attempted to enforce the debt against the borrower. Under a guarantee of collection, the guarantor will pay only if the borrower (the “other party”) has either returned an execution of judgment without paying, the borrower has become insolvent, the borrower cannot be served with process, or “it is otherwise apparent that payment cannot be obtained from the other party.”

Guarantees of collection provided by a single guarantor are subject to the higher 50% aggregate limit discussed above. However, for purposes of the 50% limit, you must also include any loans made to that guarantor, as well as any guarantees of payment. As stated in the 1993 IDFPR Interpretive Letter, “in applying this limit, any direct loans to the Guarantor and any other collection and payment guarantees will be aggregated with the collection guarantees.”

From what you have told us, it is possible that the guarantees provided by the construction contractor should be considered guarantees of payment. If that is the case, then the Illinois Banking Act will not require you to aggregate those guarantees with the construction contractor’s loans. However, you should continue your analysis under the IDFPR rules and OCC rules discussed below.

Second Test: IDFPR Lending Limit Rules

The IDFPR has also issued administrative rules that require a separate analysis of guarantees and loans involving a single customer. 38 Ill. Adm. Code, Part 330. The IDFPR rules do not distinguish between guarantees and loans. Instead, both guarantees and loans are included in the rules’ definition of “loan or extension of credit.” 38 Ill. Adm. Code 330.10. Under the IDFPR rules, you must aggregate a loan and guarantee if the creditworthiness of the borrower does not justify the extension of credit without relying on the guarantor’s credit worthiness. 38 Ill. Adm. Code 330.110(a). The rules include three factors to consider when making this determination (38 Ill. Adm. Code 330.110(b)):

(1) Does your credit analysis and documentation (made at the time the loan was made) substantiate that the original borrower has or will have the financial capacity to repay the loan from its own assets and operations? Or is the guarantor the source of repayment?

(2) Are the loan proceeds used for the primary benefit of the borrower? Or is a substantial portion of the loan proceeds used for the benefit of the guarantor without a corresponding economic benefit to the borrower?

(3) Is the purpose of the guarantee to enhance the loan for reasons other than repayment (such as to reduce the rate of interest charged)? Would the loan not have been made without the guarantee?

The IDFPR attorney told us that these tests are directed at arrangement where the guarantor is providing guarantees for a borrower that is not truly a separate entity from the guarantor. From what you have told us, in this case, the construction contractor is separate from the developer borrowers. However, we recommend analyzing each loan to the developers, to ensure that the construction contractor is not the only source of repayment for the loans, that the developers are at least receiving “corresponding economic benefits” from the loans (even though some loan proceeds will naturally be paid to the construction contractor), and that the loans could have been made without the guarantees.

Third Test: OCC Lending Limit Rules

The IDFPR attorney also recommended applying the OCC’s lending limit rules to Illinois state-chartered banks, even though they are not regulated by the OCC. The OCC’s rules provide two tests for determining whether a guarantor and borrower are truly separate entities or whether their obligations should be aggregated.

Direct Benefit Analysis

Under the OCC’s direct benefit test, a loan must be aggregated with a guarantee when the loan proceeds are transferred to the guarantor, “other than in a bona fide arm’s length transaction where the proceeds are used to acquire property, goods, or services.” 12 CFR 32.5(b). Here, some of the proceeds from your loan to a developer will be transferred to the construction contractor. However, if the proceeds are used to purchase the construction contractor’s services in a bona fide arm’s length transaction, the direct benefit test will not apply, and you will not have to aggregate the developer’s loan with the construction contractor’s guarantee.

Common Enterprise Analysis

Under the OCC’s common enterprise test, a loan must be aggregated with a guarantee when the borrower and guarantor are in fact part of a single common enterprise. 12 CFR 32.5(c). Similar to the IDFPR rules, the OCC’s rules do not distinguish between guarantees and loans in defining a “loan or extension of credit.” 12 CFR 32.2(q)(1)(i). A common enterprise between a borrower and guarantor is deemed to exist when:

(1) The expected source of repayment for the loan is the same as the source of repayment for the guarantee and neither the borrower nor the guarantor has another source of income to fully repay the loan,

(2) The borrower and the guarantor are under common control and have substantial financial interdependence,

(3) The borrower and the guarantor both use the loan proceeds to acquire more than 50 percent of the same business, or

(4) The OCC determines that a common enterprise exists “based upon an evaluation of the facts and circumstances of particular transactions.”

From what you have told us, there are no reasons to suspect that the second or third factors would apply here: the construction contractor and the developers are not under common control, and they are not using the loan proceeds to purchase a business. You may have to rule out the first factor by showing that the developers have a source of income that could fully repay the loan, as well as the construction contractor. The fourth factor leaves the analysis in the OCC’s discretion, which would not apply here, as you are regulated by the IDFPR. However, the attorney we spoke to indicated that the IDFPR also will examine the facts and circumstances of each transaction to determine that your institution has not violated its lending limits.