When it comes to fast food dining, the combo meal makes life easy.  When it comes to applying combination rules to a bank’s lending limits, though, it’s not quite as simple as a quick drive-thru at your local fast food joint.

Bankers are well acquainted with lending limits imposed by law (for South Dakota state banks the general lending limit is found at SDCL 51A-12-2, and lending limits for national banks are found at 12 U.S.C. § 84).  Applying those lending limits may become complicated, however, if a bank makes a loan to borrower A but the law requires that the loan to borrower A be combined with loans the bank may have to borrower B.  In the case of national banks the OCC has a regulation entitled “Combination Rules” which is codified at 12 C.F.R. § 32.5.  For state banks in South Dakota, our banking statutes and regulations are mostly silent on the issue of when loans to one borrower must be combined with its loans to another borrower.  However, in this author’s experience the South Dakota Division of Banking has often referred to and applied the OCC’s combination rules for purposes of applying South Dakota’s lending limits to state banks.

The OCC’s combination rules identify two tests for determining whether a loan to borrower A must be combined with the same bank’s loans to borrower B:   when the loan to borrower A is used for the direct benefit of borrower B (the direct benefit test) or when a common enterprise exists between borrowers A and B (the common enterprise test).

The OCC Direct Benefit Test

The OCC’s direct benefit test is fairly simple to apply.  If the proceeds of a loan to borrower A end up in the pockets of borrower B the direct benefit test is triggered (and the bank must combine its loans to borrowers A and B for purposes of measuring its compliance with lending limits), with one significant exception.  The direct benefit test will not be triggered if the proceeds of the loan to borrower A are used in a bona fide arm’s length transaction to acquire property, goods, or services.  Thus, if borrower A uses the proceeds of the loan to purchase a piece of real estate from borrower B on an arm’s length basis the bank need not combine its loans to borrower A with its loans to borrower B for lending limit purposes.

The OCC’s Common Enterprise Test

The OCC’s common enterprise test is not quite as straightforward as the direct benefit test.  Under the OCC’s rules a common enterprise can exist in two situations:  if a bank’s loans to borrower A and borrower B have the same expected source of repayment and neither borrower has another source of income from which the loan (together with its other obligations) may be fully repaid, or if borrowers A and B are related through common control and substantial economic interdependence exists between them.

The OCC’s expected-source-of-payment trigger for combining rules is implicated when a bank makes a loan to borrower A but requires borrower B to guarantee that loan.  The guaranty creates a common source of repayment for the bank’s loan to borrower A and any loans it may have to borrower B.  However, the guaranty from borrower B would not require the bank to combine its loans to borrowers A and B, under the OCC’s rules, if the loan to borrower A has an adequate source of repayment separate from borrower B’s guaranty.

The OCC’s Combination Rules

The second situation that creates a common enterprise under the OCC’s combination rules is when borrowers A and B are related through common control and “substantial economic interdependence” exists between them.  Under the OCC’s rules substantial financial interdependence exists when 50% or more of borrower A’s gross receipts or gross expenditures are derived from transactions with borrower B.  It is essential, therefore, when a bank makes loans to related companies for the bank to closely examine the economic relationships between those companies to determine whether they have substantial financial interdependence.

Banks should also be aware that both South Dakota and the OCC have special rules applicable when a bank makes loans to partners, partnerships, or entities within a corporate group.  Under South Dakota law if a bank makes a loan to borrower A and borrower A invests the proceeds of that loan in a partnership or corporation, the bank is not required to combine that loan with loans the bank may also have with that partnership or corporation unless the bank is relying on the assets of that partnership or corporation as the source of repayment for the loan to borrower A.  On the other hand, under the OCC’s rules a loan to borrower A and a bank’s separate loans to a partnership are combined if borrower A invests the proceeds of that loan in the partnership.  Similarly, under the OCC’s rules a loan to a partnership is deemed to be a loan to each of its partners.  That rule is not applied, however, in the case of limited partnerships or other “joint ventures or associations” if the members of the entity are not generally liable for the entity’s debt.  Thus, the OCC has typically not applied its combination rules when a bank makes a loan to a limited liability company and also a loan to one of its members, because the members of an LLC are not generally liable for the LLC’s debts.

Finally, the OCC has rules for loans to a corporate group.  The total of all loans made by a national bank to members of a corporate group may not exceed 50% of the bank’s capital and surplus.  However, a bank must still examine each loan it makes to members of a corporate group to see if they need to be combined for either the direct benefit test or the common enterprise test.

Applying the regulators’ combination rules can become complicated when measuring a bank’s compliance with its lending limits. Attention to the details is crucial.

Charles D. Gullickson is an attorney at Davenport, Evans, Hurwitz & Smith, LLP in Sioux Falls, SD. Contact Charles at cgullickson@dehs.com.