An audit has revealed two loans to an executive officer where the demand clause was not included in the promissory note. I want to respond appropriately to the audit. I know what to do to ensure that there are no future occurrences. However, I am unsure of what, if any, corrective action should be taken for the existing two loans. Should we have the loan officer execute a new promissory note that includes the demand clause to correct the deficiency? Any suggestions are much appreciated. Thank you.

You don't necessarily need to execute a new note but you do need to modify it to add the due on demand clause.

This is a violation of the Reg. and subject to CMP if not corrected.

Sec. 215.11 Civil penalties.
Any member bank, or any officer, director, employee, agent, or other person participating in the conduct of the affairs of the bank, that violates any provision of this part (other than § 215.9) is subject to civil penalties as specified in section 29 of the Federal Reserve Act (12 U.S.C. 504).

I haven't looked at the CMPs for some time but if memory serves they can run from $5,000 up to $1,000,000 per day for each day the violation remains outstanding.

Thank you so much Dan. I am so glad I asked the question!

I have one more question related to the requirement for an executive officer to submit a detailed financial statement prior to any extension of credit. Does this mean that the financial statement is to be submitted to the whole board of directors? Thank you.

It is submitted to the bank and whoever is in charge for approving the loan must consider it in the approval process. Whether you choose to send that much information to the board of directors is up to you, unless the loan also needs prior board approval rather than just reporting.

At my bank the Internal Auditor presents the Reg. O Related Interest Survey to the Board each January. Along with this, she also makes sure that she has up-to-date personal financial statements for all insiders. She keeps track of this each year and keeps the PFS in a separate file from the loan file with limited (need-to-know) access. If someone needs to update the PFS, she contacts them and stays on it until she gets it.

Unless there is a requirement for this to happen annually (some States used to require it), I would say this is a little overkill unless everyone is borrowing form the bank. Also, having the IA do this jeopardies all sorts of independence issues unless you are going outside for your Reg. O independent audits..

The loans in questions DID require prior approval, however no financial statement was submitted at the time. In my efforts to respond to the audit item, should the financial statement be submitted now? I appreciate your opinion.

If the board is doing its job correctly, it should be weighing the creditworthiness of the borrower (in this case the insider) both to ensure the insider is deserving of the credit, but also to make certain the credit is not being extended with any preferential feature. Part of that evaluation, I would argue, is the borrower's PFS. For what other reason would the PFS have to be in file for than to be reviewed as one element of the board's duty to approve/disapprove the credit?

I totally agree John. However, at the point and time when the extension of credit was made, the request was not preceded by a detailed financial statement of the executive officer. I need to respond to the audit item and wonder if this is a finding that we should go back and try to rectify by providing a financial statement to the board now. This may be one of those items that we just acknowledge the finding and state what we will do to ensure that it does not occur in the future. Of course, our new written procedures will include the step in the process.

You can't cure it. Can you get one now. Sure. I would have to question your overall Reg. O policy and procedures if a loan can go to the board for approval without a current financial statement. How in the world do they determine the EO is creditworthy without it. I think there should have been a more substantial finding than just the lack of a FS in the audit.

This is one of those findings that challenge not only the process (of placing required approvals before the directors), but also the directors themselves, who should not have approved the credit without the PFS.

Thank you John and rlcarey. I agree with you both. The process was that the executive officers submitted an updated financial statement annually to the bank President. There have not been many covered loans here, but procedures will be written for future reference and training provided. I appreciate all your help and comments.