Consistent with common industry practice, credit unions should make credit decisions based on a full understanding of the risks posed by commercial borrowers. Such risks include the potential impact of the influence associated individuals or entities have on a borrower. Influence stems from interdependent business actions between different borrowers, reliance on repayment from other borrowers, and borrowers that share common management and ownership. In some cases, such influence can have a material impact on a borrower’s operational activities or loan repayment ability.
NCUA regulation § 723.2, Definitions, defines an associated borrower as any person or entity that has a shared ownership, investment, or other pecuniary interest in a business or commercial endeavor with a borrower. This means any person or entity named as a borrower or debtor in a loan or extension of credit. Associated borrowers also include any person or entity (such as a drawer, endorser, or guarantor) that is engaged in a common enterprise with a borrower, or that derives a direct benefit from a loan to a borrower. Exceptions for partnerships, joint ventures and associations are discussed later in this section.
Understanding the concept of an associated borrower is critical to ensure a lender aggregates total credit risk exposure to a borrower and avoids undue concentrations relative to the lender’s net worth.
Credit unions should require commercial borrowers to disclose associated individuals and entities in order to fully identify all influences on a borrower. A credit union should understand the overall borrowing relationship, and perform an appropriate risk assessment based on available information. Associated borrower relationships can be complex, and credit unions should have consistent and definitive criteria for identifying associated individuals and/or entities.
Determining the Associated Borrower Relationship
An associated borrower relationship is established when a borrower (person or entity) receives a direct benefit from the proceeds of a loan to another borrower (person or entity), or when a borrower is engaged in a common enterprise with another borrower (of the credit union). When a direct benefit or common enterprise exists amongst borrowers, loans to the borrowers must be aggregated and the total applied against the regulatory limit on loans to one borrower or group of associated borrowers as defined in NCUA regulation § 723.4(c).
Direct Benefit
A direct benefit is established when the proceeds of a loan or extension of credit to a borrower, or assets purchased with those proceeds, are transferred to another person or entity. A direct benefit is not established in the event of a bona fide arm's length transaction, in which the proceeds of a loan are used to acquire property, goods, or services.
Example: A credit union grants an LLC borrower (Apple LLC) a $1,000,000 loan. Apple LLC uses the loan proceeds to lend $600,000 to another LLC (Orange LLC) and pays $400,000 to a third LLC (Pear LLC) for construction services via a bona fide arm’s length transaction. In this case, Orange LLC is an associated borrower of Apple LLC, because it receives direct benefits from the proceeds of the loan to Apple LLC. Even though Pear LLC, a borrower of the credit union, is also a beneficiary of the loan proceeds, a direct benefit is not established. This is because Pear LLC received funds in exchange for construction services it delivered in an arm’s length transaction. In this example, Pear LLC is not considered an associated borrower of Apple LLC.
A credit union should understand how parties benefit from the flow of funds because the ultimate use of funds is critical in determining if a direct benefit exists. As a result, credit unions should fully understand and document the disbursement of a loan.
Common Enterprise
There are three tests a credit union can use to determine if a borrower is engaged in a common enterprise with another borrower. A common enterprise is established if one or more of these tests are met:
- Common source of repayment test
- Common control and financial interdependence test
- Majority voting rights in business acquisition test
Common Source of Repayment Test
This test is satisfied if:
- 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.
An employer will not be treated as a source of repayment because of wages and salaries paid to an employee, unless the standards described in the second test for common control and financial interdependence described below are met.
This test focuses on the ultimate source of repayment. Credit unions should have a full understanding about the primary source of revenue that a borrower has to repay its loans. Such an understanding is the only way to establish whether different loans have a common repayment source.
In more complex business arrangements, an operating entity that delivers goods and services to the end user generates income. Such an operating entity may lease equipment, real estate, or management service from supporting entities. Because the supporting entities depend on the operating entity for revenue they need to make their loan payments, loans to the supporting entities have the same source of repayment as loans to the operating entity.
Financial stress experienced by the operating entity can carry through to the financial wellbeing of its supporting entities and impact the supporting entities’ abilities to repay obligations. In this example, the supporting entities are engaged in a common enterprise with the operating company because they depend on the operating entity’s success and are considered its associated borrowers.
Example: Smith Corporation (an operating entity) leases equipment from Johnson Industries (a supporting entity). Johnson Industries has no other source of income besides the lease revenue from Smith Corporation, making the repayment of Johnson Industry’s loan dependent on lease payments from Smith Corporation. Therefore, loans to both borrowers have the same source of repayment and rely on the successful operation of Smith Corporation. In this case, both borrowers are engaged in a common enterprise and are associated borrowers.
Example: A credit union makes three separate loans to three separate borrowers who are each partners in the same dental practice. Each partner’s sole source of income comes from distributions from the dental practice. Because the three loans share the same source of repayment (income from the dental practice), the common source of repayment test is met. The three borrowers are engaged in a common enterprise and are associated borrowers.
If the three borrowers received income in the form of wages instead of profit distributions, the common source of repayment test would not be met. An employer is not treated as a common source of repayment unless the following common control and financial interdependence test is met.
Common Control and Financial Interdependence Test
A common enterprise exists when borrowers are related by common control (or one borrower controls the other) and there is substantial financial interdependence between the borrowers.
Common control
A borrower (person or entity) is deemed to have control of another borrower when it:
- owns, controls, or has the power to vote 25 percent 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
When evaluating a borrowing relationship, a credit union should first identify the owners of each related borrower and each owner’s ownership interest. Owners with more than 25 percent or more ownership meet the first condition. A credit union should then determine if the borrowers meet the second condition for financial interdependence.
Financial interdependence
This condition focuses on intercompany transfers of funds, whether in the form of fees paid for goods or services or in the form of inter-company loans, dividends, and other distributions to owners, capital contributions, and similar payments. There is substantial financial interdependence between borrowers when 50 percent or more of one borrower’s gross receipts or gross expenditures (on an annual basis) are derived from transactions with another borrower. Gross receipts and expenditures include gross revenues or expenses, intercompany loans, dividends, capital contributions, and similar receipts or payments.
Example: Borrower Iron LLC has three shareholders, each of whom own 33 percent of the total shares. Because each shareholder owns more than 25 percent of the shares, all three have common control of Iron LLC. All three shareholders have other income sources. While the first two shareholders receive 60 percent of their incomes from Iron LLC, the third shareholder only receives 40 percent of his income from Iron LLC. In this example, the first two shareholders meet the financial interdependence condition, because more than 50 percent of their incomes came from Iron LLC. A common enterprise exists between the borrower and these shareholders, who are associated borrowers of Iron LLC. The third shareholder does not meet the financial interdependence condition, and is not an associated borrower.
Majority Voting Rights in Business Acquisition Test
A common enterprise exists when separate borrowers obtain loans or extensions of credit to acquire a business enterprise in which the borrowers will own more than 50 percent of the voting securities or voting interests.
The third test requires aggregating the ownership interest of separate borrowers that have used loan proceeds to purchase an interest in an entity. If the aggregated ownership of those borrowers is higher than 50 percent or if they control 50 percent of the voting rights, the borrowers are engaged in a common enterprise and are considered associated borrowers.
Example: Five individuals purchased an LLC business entity together, and each owns 20 percent of the LLC. The first three owners borrowed from the credit union and used the loan proceeds to invest in the LLC. The remaining borrowers used their own funds, and did not borrow from the credit union. Because the aggregated ownership of the first three borrowers (who borrowed from the credit union) is more than 50 percent, these borrowers are engaged in a common enterprise, and are associated borrowers. The two borrowers that did not use loan proceeds to invest in the LLC are not associated borrowers.
Partnership Exclusion
There are three exceptions to the associated borrower for partnerships, joint ventures and associations:
First Exception: 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.
This exception excludes the associated debt of a member or partner when the borrower is a partnership, joint venture or association except when a direct benefit or common enterprise exist between the member or partner and the borrower (partnership, joint venture or association). However, the partnership, joint venture, or association loan is an associated debt of the member or partner when the member or partner is directly liable for that debt.
In this case, a direct benefit or common enterprise only exists when loans or extensions of credit are made to the member or partner to purchase an interest in the partnership, joint venture or association.
Example: Partnership A is owned by two individuals who are general partners. The partnership has direct debt of $100,000, and each individual has a separate loan with the credit union of $50,000 each. In this case, the debts associated with the general partners is not associated debt of the partnership. The partnership’s associated relationship is just the direct loan of $100,000.
If the purpose of the two $50,000 loans to the individual partners is to invest in the partnership, the loans would be associate debt of the partnership. The associated relationship for partnership A is the direct loan of $100,000, plus each of the partner’s individual $50,000 loans for a total partnership associated relationship of $200,000.
For each individual partner, the associated relationship is $150,000, because the partnership debt is attributed to each individual the partnership debt of $100,000, plus each individual loan of $50,000.
Second Exception: 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.
As the members and partners of partnerships, joint ventures, and associations are liable for the borrowing entity’s debt, the debts of the borrowing entities are included in the associated borrower calculation for each member or partner unless the partner or member is a limited partner. By law, limited partners are not liable for the partnership debt. The borrowing partnership’s debts should not be included in the calculation of the aggregate associated debt of the individual limited partners.
Example: Partnership B is owned by one individual general partner and ten limited partners. The partnership direct debt is $100,000, and each individual—including the limited partners—has a separate $50,000 loan with the credit union. In this case, the Partnership B associated relationship is $100,000, because the individual loans are not invested in the partnership. The associated debt of the partners is not attributed to the partnership.
The one individual general partner’s associated relationship is the separate individual loan of $50,000, plus the partnership debt of $100,000, for a total associate relationship of $150,000.
For each limited partner (those partners without direct liability for the borrower’s debt) the associated debt is only the direct individual $50,000 loan, not the partnership loan (the limited partners are not liable for that debt). Assuming the limited partners do not have any other loans with the credit union, the associated relationship for each is $50,000.
Third Exception: 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.
This exception establishes that the related debt of one partner or member is not an associated debt of the other partners or members. Members or partners of a partnership, joint venture, or association are not considered associated borrowers of the other members or partners of the partnership, joint venture, or association unless there is either a direct benefit or a common enterprise.
Example: Partnership A is owned by two individuals (general partners). The partnership has direct debt of $100,000 and each individual has a separate loan with the credit union of $50,000. In this case, the debts associated with the general partners is not associated debt of the partnership. The partnership’s associated relationship is just the direct loan of $100,000.
For each individual partner, the associated relationship is $150,000, because the partnership debt is attributed to each individual the partnership debt of $100,000, plus each individual loan of $50,000. This exception clarifies that the loans of one partner are not associate debt of the other partner. The $50,000 individual loan by one partner are not attributed to the second partner.
Single Borrower Limit
Consistent with regulatory requirements for banks and other financial institutions, NCUA regulation § 723.4(c) requires the aggregate dollar amount of commercial loans to any one borrower or group of associated borrowers may not exceed the greater of:
- 15 percent of the federally insured credit union’s net worth, or $100,000, plus
- An additional 10 percent of a credit union’s net worth if the amount that exceeds the credit union’s 15 percent general limit is fully secured at all times with a perfected security interest by readily marketable collateral.
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 is excluded from the single borrower limit.
Waivers that were granted for a single borrower or borrowing relationship to exceed the limits set forth in §723.8, Aggregate member business loan limit; exclusions and exceptions, of the previous rule will remain in effect until the aggregate balance of the loans outstanding associated with the relationship is reduced and in compliance with the requirements of § 723.4(c).
Managing Within Regulatory Limits
Credit unions should ensure their aggregate activities don’t breach regulatory limits and plan for unforeseen contingencies.
Setting an internal limit below the regulatory limit is a prudent business practice for credit union, however, it is not a supervisory expectation.
Risk Management Beyond the Requirement
NCUA regulation part 723, Member Business Loans; Commercial Lending, requires credit unions to adequately identify and aggregate all associated borrowers to effectively control total exposure to a borrower or a group of associated borrowers. Tracking associated borrowers is critical, as credit unions need to aggregate total credit risk per borrower and avoid undue concentrations relative to their net worth.
Credit unions should be mindful that certain factors can change the dynamics of associated entities. These factors include multiple loans relying on a single guarantor, significant transactions between the same entities, joint ownership of assets or shared use of assets, and others. Such factors should be monitored, to the extent practicable, through a strong ongoing diligence process that keeps a focus on aggregate exposure. A risk-focused approach will ensure compliance with the regulation and, more importantly, foster the development of policies and processes that timely identify material risk influences in a borrowing relationship.
Determining associated borrowers can be complicated. Credit unions should perform a comprehensive assessment of the overall borrower’s operations, as well as cultivate a full understanding of the borrower’s business relationships.
Last updated November 25, 2016
