Boli Legal Services

Regulatory Environment

Purchase by banks of bank-owned life insurance (“BOLI”) as a method to informally finance benefit expenses is a subject that has been addressed by federal bank regulators. Most notably, the Office of the Comptroller of the Currency (the “OCC”) issued Banking Circular 249 in 1991 on the subject, establishing quantifiable standards a bank could employ to determine whether an investment in BOLI would be permissible for that bank. The other federal financial institution supervisory agencies, including the Federal Reserve Board (the “FRB”), the Federal Deposit Insurance Corporation (the “FDIC”), and the Office of Thrift Supervision (the “OTS”), thereafter followed the lead of the OCC on the subject of BOLI, essentially applying Banking Circular 249 to BOLI investments by financial institutions subject to these agencies’ respective jurisdictions. Banking Circular 249 was replaced by the OCC in 1996 with issuance of OCC Bulletin 96-51, and in July 2000 with issuance of OCC Bulletin 2000-23.

On December 7, 2004, the OCC, the FRB, the FDIC, and the OTS issued the “Interagency Statement on the Purchase and Risk Management of Life Insurance.” The Interagency Statement on the Purchase and Risk Management of Life Insurance may be found in OCC Bulletin 2004-56 for national banks, OTS Thrift Bulletin 84 for state- and federally chartered thrifts, Supervisory Letter SR 04-19 for state-chartered, FRB-regulated commercial banks, and FIL-127-2004 for state-chartered, FDIC-regulated commercial banks and savings banks. Thirty pages long, the interagency BOLI guidance is very comprehensive and clarifies the federal bank regulatory agencies’ expectations regarding BOLI program implementation, operation, and ongoing risk assessment. For new BOLI purchases, the interagency BOLI guidance requires that financial institutions have a comprehensive risk management process for purchasing and holding BOLI. Moreover, financial institutions that currently hold BOLI must complete an annual assessment of their BOLI investments as described in the “Risk Management of BOLI” section of the interagency BOLI guidance.

The interagency BOLI guidance states that “before entering into a BOLI contract, institutions should have a comprehensive risk management process for purchasing and holding BOLI.” This process necessarily entails development of a detailed BOLI investment policy describing, at a minimum – (1) senior management and board oversight of the BOLI investment; (2) the single insurer and aggregate insurer BOLI investment limits established by the institution; (3) the institution’s pre-purchase analysis of BOLI products and alternatives; and (4) the institution’s risk assessment, management, monitoring, and internal control processes, as well as the appropriate internal audit and compliance functions. A detailed BOLI investment policy will assist a financial institution’s board in documenting the complex risk characteristics of the BOLI investment and in explaining the role BOLI is intended to play in the institution’s overall business strategy.

In addition to conducting a risk assessment as part of a thorough pre-purchase analysis, financial institutions must also monitor BOLI risks on an ongoing basis. The interagency BOLI guidance provides that an institution should review the performance of its BOLI assets with the board of directors at least annually. More frequent reviews are appropriate if there are significant changes to the BOLI program, such as additional purchases, a decline in the financial condition of the insurance carrier(s), anticipated policy surrenders, or changes in tax laws or interpretations that could have an impact on the BOLI’s performance.

Each institution must also establish internal policies and procedures that limit the aggregate cash surrender value of policies from any one life insurance company, as well as the aggregate cash surrender value of life insurance policies from all life insurance companies. When establishing these internal BOLI limits, an institution must consider its legal lending limit, the capital concentration threshold, and, in the case of state-chartered bank and thrift institutions, any applicable state restrictions on BOLI holdings. The federal bank regulatory agencies expect management to be able to justify an institution’s aggregate BOLI holdings above 25% of capital. The guidance notes that institutions approaching or exceeding the 25% of capital threshold can expect examiners to “more closely scrutinize the risk management policies and controls associated with the BOLI assets and, where deficient, to require corrective action.” Parenthetically, it is interesting to note that the OTS Northeast Regional Director stated in a Fall 2004 letter to the 274 OTS-chartered thrifts in the 12-state OTS Northeast Region that “as a rule of thumb,” thrifts intending to purchase BOLI at or above 20% of capital should discuss such purchases with the OTS prior to consummation of the transaction. Alone among the four federal bank and thrift regulatory agencies in its supervisory approach regarding the rigidity of BOLI investment limits, the OTS has since July, 2002, required thrifts to request permission before investing more than 25% of total capital in BOLI.

Grady & Associates offers a full menu of legal services that would permit any bank to make a prudent BOLI investment and not be exposed to challenge from bank regulatory agencies, the IRS, or even shareholders alleging excessive compensation obligations. BOLI vendors estimate that nearly one fourth of the nation’s 11,500 banks and thrifts have BOLI programs. With BOLI transactions having become common in the community bank marketplace only within the last several years, community banks should remember the age-old paradigm: there is a “right way” to do a BOLI financing and a “wrong way” to do a BOLI financing. Regulators are not on a quest to preclude banks’ use of BOLI. No doubt, the vast majority of banks that purchase BOLI are in compliance. The essence of regulation is to search for those few banks that push the envelope.

As a boutique law firm exclusively devoted to the representation of financial institutions, Grady & Associates routinely works as special counsel to financial institutions contemplating the adoption of BOLI-financed bank compensation benefit programs.

Documenting BOLI Bank Regulatory Compliance

Grady & Associates has developed a BOLI compliance practice niche. Over the years, we have become familiar with BOLI bank regulatory issues affecting state-chartered commercial banks, savings associations, and savings banks under the laws of nearly 40 states. This is noteworthy because a number of states’ banking laws contain more restrictive BOLI purchase standards than those enunciated in the interagency BOLI guidance. As an example, depository institutions chartered under the laws of Iowa, Nevada, and New Jersey, among others, face more restrictive limitations under state law than banks regulated solely under the standards of the interagency BOLI guidance.

Our BOLI knowledge under state banking laws accumulated in client engagements beginning in 1997. Our collective client engagement experience in this area makes Grady & Associates the most cost effective resource in the legal marketplace to determine the legal authority, standards, and limitations for the purchase of BOLI by depository institutions chartered in any state jurisdiction.

We find that new benefit plans are typically established at the time a community bank decides to invest in BOLI. BOLI is the “pay for” that facilitates new benefits at no cost to the employer. Our firm is intimately familiar with the bank regulatory issues associated with a financial institution’s purchase of BOLI used to finance a compensation benefit obligation such as a Supplemental Executive Retirement Plan (“SERP”). We furnish bank clients undertaking a BOLI financing with sample board resolutions to evidence board approval of (i) the BOLI investment and (ii) the BOLI-financed compensation obligation. These board resolutions are a critical part of BOLI documentation because they memorialize the bank's compliance with the interagency BOLI guidance and any state law equivalent.

As with most financial instruments, BOLI can be complicated and is not without risk. Furthermore, BOLI transactions are unique and represent activities that differ greatly from the main business activities of most financial institutions. Grady & Associates addresses federal bank regulatory agency policy governing everything from pre-purchase analyses to the applicable risks associated with BOLI relative to its impact on capital and earnings. Grady & Associates’ experience and familiarity with BOLI transactions can assist depository institutions by ensuring that purchases of BOLI are consistent with safe and sound banking practices. The interagency BOLI guidance recommends that banks fully understand the nature and associated risks of BOLI prior to any purchase decision.

Documenting Insurable Interest Compliance: Avoiding IRS Scrutiny

An essential element in all BOLI programs is that there is an underlying business purpose to the transaction. The business purpose for a BOLI transaction generally involves protecting the bank employer against the costs/loss due to the death of key employees, and offsetting the bank's future obligations to its employees under retirement and benefit plans. Adoption of a group term carve out plan is a tool often used by banks to establish a legitimate business purpose for a BOLI financing. An executive group term carve-out split dollar life insurance plan is a replacement for executives' participation in a bank's group term life insurance program (except for the non-taxable $50,000 group term life insurance death benefit). The executive group term carve-out split dollar life insurance plan provides comparable life insurance coverage to what the executives have under a bank's group term life insurance program for all employees, while reducing the annual increasing expense of group term life insurance and replacing it with an earning asset.

Grady & Associates issues legal memoranda for client depository institutions regarding BOLI compliance with applicable state insurable interest law. Given the heightened interest of the IRS in BOLI programs, including insurable interest, the method by which an institution determines both the existence and extent of insurable interest in its employees should be thoroughly reviewed, understood, documented, and capable of clear articulation by bank management. As a law firm with over 250 some bank and thrift clients and having represented countless more banks and thrifts in our professional careers, we find few, if any, boards that document the basis upon which the board determined the validity of an insurable interest in the individuals covered by the BOLI financing prior to the purchase of the insurance, thus making these institutions susceptible to (i) an IRS BOLI tax audit initiative and (ii) bank regulatory criticism that the BOLI financing does not comply with the interagency BOLI guidance standards.

Insurable interest laws vary widely state to state. Insurable interest laws can be established by statute, regulation, or through common law. While most states have formal insurable interest statutes for corporations, including banks, other states have no such provisions. Some states simply grant an insurable interest to employers in all of their employees, while other state statutes differentiate between employees and more senior-level management personnel, like directors and officers. Many states also have notice and consent requirements that a bank must fulfill before obtaining coverage on any employee.

Soliciting the participation of an employee in a BOLI program also may implicate state insurable interest law. The written language used to obtain consent, as well as the solicitation approach initiated by management, may be prescribed by statute. Additionally, other procedural requirements may be mandated by state insurable interest law requiring close monitoring of a BOLI program for continued compliance with state law. For example, New York has an insurable interest statute that addresses procedures for when an insured employee leaves the company.

Perhaps the most critical consideration a state insurable interest statute may address is the extent of an institution’s insurable interest in the employee pool. Policy coverage far in excess of the risk of loss of the bank may belie the intended business purpose for purchasing the life insurance policies. Several state insurable interest statutes provide that a company has an insurable interest in its officers and directors, but limit the insurable interest in other employees to the extent of the company’s projected, unfunded benefit obligations for such employees.

Some corporations consider establishing out-of-state trusts for the purpose of purchasing BOLI policies under more favorable provisions of state insurable interest law. Many times the state where the trust is located will provide the employer with a larger insurable interest in its employees than the corporation's “home state” insurable interest law might provide, and relax the notice and/or consent requirements. In this situation, the insured employees usually reside in one state, with the trust located in a different state with no nexus to the employees who are the subject of the BOLI policies. This practice, however, is subject to ongoing challenge from plaintiff's bar.

There are still good tax reasons and sound insurance law reasons to make certain that a bank buying BOLI has an insurable interest under “home state” law in the lives of the people covered by BOLI, that the amount of the insurance bears a substantial relation to the risk being insured, and that consent of the insured be obtained in those cases in which counsel concludes consent is necessary. The stakes are too high for a bank to ignore home state insurable interest law or to ignore the tax consequences if the insurance bought by the bank is recharacterized by the IRS as something else.

Recognizing the existence and extent of state insurable interest law will help a bank or BOLI sales organization document a clearly articulated BOLI program in full compliance with applicable state laws.

Executive Compensation Planning

Supplemental executive retirement plans or SERPs are now essential to compete for talent within the banking industry. Qualified plans simply do not provide top executives with benefits that are in line with final pay or reflect the shareholder value top executives create. Caps on qualified plan contributions and distributions, as well as Social Security, often limit executives' retirement benefits to 30% to 50% of final pay, while lower-paid bank staff retire at 70% to 90% of final pay. A SERP can help your bank deliver retirement benefits commensurate with executive pay. A majority of “public company” (SEC-reporting) banks and thrifts provide a SERP benefit for senior management.  

As a bank adopts SERP or split dollar arrangements, it is essential that one advisor consider the “big picture” and review change-in-control issues incident to these compensation benefit programs. Grady & Associates advises clients concerning strategies to lessen the impact of §280G of the Internal Revenue Code (a provision which denies deductions to corporations for the payment of any excess “parachute payments” and imposes a nondeductible 20% excise tax on the recipient of any excess “parachute payments’) and positions executive SERP recipients for optimal contractual rights vis-à-vis any acquirer. Ensuring that senior management compensation issues are satisfactorily addressed in any merger and acquisition scenario requires foresight and planning long before any acquisition offer arrives. With our §280G assessment of executive contract rights, management will be able to make certain that a bank's SERP agreements, in conjunction with existing employment agreements and stock option plan grants, are well conceived and well informed.

A snapshot assessment of an executive's compliance posture vis-à-vis the limitations of Internal Revenue Code §280G is a routine component of Grady & Associates' executive compensation planning services that provides a client with ideas for possible improvement in the design of the SERPs to position proposed SERP recipients for optimal standing vis-à-vis §280G challenges. Obtaining the optimum SERP change-in-control benefit, along with other favorable contractual provisions, is a once in a lifetime opportunity, and our firm has considerable experience with successfully convincing boards to approve management-friendly SERP design, particularly in the change-in-control context. If the proposed recipients of a SERP receive the optimum SERP change-in-control benefit, that contractual entitlement probably results in a larger monetary benefit than the severance benefit received under an employment contract, making it worthwhile from an executive's personal perspective to strive for the best SERP change-in-control benefit possible. Adequate §280G planning is not the only thing that makes for a well-crafted SERP. These are other features of a good SERP that we routinely incorporate into a company's SERP arrangement.

Application of §409A to Deferred Compensation Arrangements

On October 22, 2004, §409A of the Internal Revenue Code became law.  §409A applies to compensation that is earned and vested in one tax year but paid in another, specifically so-called nonqualified deferred compensation plans such as ––

- Salary Continuation Agreements,

- Director and Executive Elective Income Deferral Agreements, and

- the severance provisions of Employment Agreements and Change of Control Agreements.

§409A initially applied to amounts deferred after 2004 (as well as previously deferred amounts that were not yet earned and vested before the end of 2004).  The IRS first issued guidance under §409A in Notice 2005-1 released on December 20, 2004.  Notice 2005-1 provided transitional relief during 2005 and generally gave taxpayers until December 31, 2005, to bring their written plan documents into compliance with §409A.  The notice also provided that “good faith compliance” was adequate under the standards set forth in the notice.  However, the most thorough guidance with respect to §409A is contained in the proposed and final regulations.

On September 29, 2005, the Internal Revenue Service and the U.S. Department of Treasury issued proposed regulations on the treatment of nonqualified deferred compensation plans and arrangements under §409A. On April 10, 2007, final regulations under §409A were issued.  The final regulations generally follow the proposed regulations, although there are some significant differences.  The final regulations generally are effective January 1, 2008.  On September 10, 2007, the Internal Revenue Service issued Notice 2007-78, which provided limited relief from the January 1, 2008 compliance deadline for plan sponsors to bring their plan documents into compliance with §409A and the related Treasury regulations.  In response to concerns by tax and benefit practitioners that Notice 2007-78 failed to provide plan sponsors sufficient relief, the IRS issued Notice 2007-86 on October 22, 2007.  Under Notice 2007-86, employers have until December 31, 2008, to amend nonqualified deferred compensation plans and arrangements for compliance with §409A and the final regulations, including the specification of time and form of payment.  Nonqualified deferred compensation arrangements subject to §409A must continue to comply in operation with §409A on a reasonable, good faith basis based on compliance with Notice 2005-1 or the final regulations through December 31, 2008.  Beginning January 1, 2009, full compliance with the final regulations is required.  A “savings clause,” alone, i.e., a plan provision that says the plan is to be construed in accordance with §409A, will not be enough to override specific noncompliant terms or missing terms in the plan.

The text of §409A itself states not only that a nonqualified deferred compensation arrangement must actually be operated in compliance with the various requirements of §409A but also that the plan document itself must by its terms provide for deferrals and payments and other plan transactions that in all cases would comply with §409A.  The tax consequences are severe for a nonqualified deferred compensation plan that does not comply with §409A both in terms of the plan’s operation and in terms of the plan’s form.  If a nonqualified deferred compensation plan fails to comply with §409A, the tax consequences are immediate inclusion in income of amounts previously deferred, plus an interest penalty, plus a 20% excise tax penalty.

There are six circumstances in which §409A allows distributions from a nonqualified deferred compensation plan such as a SERP.  Distributions in all other cases would not comply with §409A.  The six circumstances are ––

1) separation from service, 2) disability, 3) death, 4) at a time or according to a schedule specified in the nonqualified deferred compensation plan or agreement when the compensation is deferred, 5) a change in control, and 6) unforeseeable emergency.

In one and only one of these six cases –– separation-from-service –– a six-month delay must be imposed before a nonqualified deferred compensation plan distribution may occur.  But the six-month delay applies if and only if two further conditions are satisfied.  First, the six-month delay applies solely to an executive who is a so-called specified employee.  In summary, the term specified employee means a key employee as defined in Internal Revenue Code §416(i) for purposes of the top-heavy nondiscrimination testing rules.  According to §416(i), a company’s key employees are ––

- officers (up to 50 officers) with annual compensation over $185,000 (for 2020),

- employees who are 5% owners of the employer, and

- employees who are 1% owners of the employer with annual compensation over $150,000.

The $150,000 compensation threshold for officers is indexed for inflation.

Second, the six-month delay applies solely in the case of officers whose employer’s stock (or the holding company’s stock) is, to use the language of §409A –– “publicly traded on an established securities market or otherwise.”  As a consequence, the six-month delay imposed by §409A applies in any case in which SERP or other nonqualified deferred compensation benefits can be characterized as separation-from service benefits.

In every case in which a six-month delay applies (whether for normal retirement, early termination, or disability benefits), the §409A rules demand that the nonqualified deferred compensation agreement itself specify whether the monthly installment benefits shall simply be delayed by six months, on one hand, or on the other hand whether the six months of delayed payments shall be made in a single lump sum at the end of the six-month delay period.

If a nonqualified deferred compensation arrangement specifies a precise date for distribution of benefits –– as opposed to making distributions conditional on separation from service –– the six-month delay imposed by §409A does not apply.  For example, if a SERP normal retirement benefit is payable precisely when an executive attains age 65, even if retirement does not actually occur at that time, the six-month delay would not be necessary, although it would continue to be necessary in the case of early termination benefits and benefits because of termination resulting from disability.  Likewise, the six-month delay is unnecessary if a SERP change-in-control benefit is a single-trigger benefit payable merely because a change in control occurs, even if employment termination does not occur simultaneously or within a fixed number of months thereafter.  This is because a single-trigger change-in-control benefit is not a separation-from-service benefit.  However, the single-trigger change-in-control benefit distribution would be permissible under §409A if and only if the event making the distribution payable qualifies as a change in control for purposes of §409A’s definition of the term change in control.  In contrast, a double-trigger change-in-control benefit (a change-in control benefit payable because of employment termination occurring within a fixed number of months after a change in control) is considered a separation-from-service benefit and the six-month delay would apply.

SEC Disclosure of BOLI-Financed Arrangements

Compensation of officers is one of many things stockholders care deeply about. But compensation of officers is a traditional board function. Stockholders generally are not entitled to exercise direct control over compensation issues under corporate law (leaving aside for the moment stock exchange and NASDAQ listing standards or tax laws that can, in some cases, require submission of compensation plans and arrangements to a stockholder vote), but it is a principle of long standing that stockholders exercise indirect control through their power to elect directors. Officer compensation is one of the things directors are evaluated on when stockholders consider and vote upon election of directors. That is the single most important reason - if not the only reason - proxy statements include elaborate executive compensation disclosures. Therefore, management should be sensitive to placing a favorable SEC gloss on new BOLI-financed compensation arrangements.

There is no universally employed standard for disclosures of BOLI-financed SERP and split dollar benefits. Executive compensation disclosures are governed by the SEC's Regulation S-K, Item 402. Careful examination of Item 402 reveals that it addresses a variety of compensation and other benefits, but it really does not squarely address how to disclose group-term carve-out plans, SERPs, and split-dollar life insurance. One therefore has to cobble together appropriate disclosures, drawing upon as much of Item 402 as applies and looking to common sense and industry practice for guidance. Having prepared numerous disclosures of these benefit arrangements for a number of our public company clients, Grady & Associates is uniquely positioned to assist with SEC proxy disclosure of BOLI-financed compensation benefits.

On February 8, 2006, the SEC proposed major changes in how corporations disclose executive compensation in proxy statements. Among other things, the SEC proposed that public companies be required to disclose the aggregate increase in actuarial value accrued during the fiscal year in defined benefit and actuarial plans, including SERPs. Disclosure rules were last overhauled in 1992, during a time when SERPs and deferred compensation plans accounted for a smaller portion of executive pay than such plans do today.

BOLI programs also merit mention in a company's Form 10-Q and Form 10-K SEC filings. Typically, a bank will purchase single premium BOLI policies whose cash values grow at the stated or current crediting rates. Banks book their cash values as "other assets". Increases in cash value are tax-free and are recognized as non-interest income. For a bank, the relevant issue concerning crediting rates is its margin to the cost of funds. Margins for BOLI products range between 150 basis points and 400 basis points, after tax. The bank books this increase in cash value in the current period as after-tax income. The BOLI asset is a non-mark-to-market asset that also lowers a bank's overall tax rate. In addition to substantial positive margins to their cost of funds, banks receive death benefits which may add approximately 50 basis points more to their total return. Upon the death of the insured, the carrier will pay benefits (accumulated cash plus death benefits) to the bank as the policy beneficiary. Cash flows back to the bank only with a death event. As BOLI programs continue to grow in popularity and size, the SEC and the investment community will expect improved disclosure. Grady & Associates can assist a bank or thrift with SEC compliance by preparing Form 10-K or 10-Q filings describing the BOLI investment and its contribution to non-interest income.

Benchmarking Peer Group Compensation for SEC-Regulated "Public Company" Banks and Thrifts

Another aspect of our services involves benchmarking peer group BOLI-financed compensation. We summarize the executive compensation practices of “public company” banking organizations identifying certain key compensation practices: the incidence of SERPs, benefit level, and number of senior executives covered; the incidence of split dollar insurance agreements along with information on the amount of BOLI purchased (if available) and the insurance coverage benefit for the executive; and the incidence of employment and severance agreements with related information on the incidence of §280G gross-up/mitigation provisions in employment, severance and SERP agreements.

Our analysis of senior management compensation practices at public company banks and thrifts is derived solely from a review of these organizations' proxy statements, annual reports to shareholders, and Form 10-K's filed with the SEC. Grady & Associates' analysis of senior management compensation practices at public company banks and thrifts enables depository institutions to hire and retain competent management by providing the depository institution's board of directors with information concerning the suitability of compensation and benefit packages vis à vis the institution's competition. The peer group compensation analysis benchmarks compensation practices at similar institutions based upon such factors as asset size, geographic location, and the complexity of the bank's business activities.

Board Retirement Plan Survey

Grady & Associates also prepares surveys showing the incidence of director retirement plans and director split dollar agreements. Like our other BOLI-financed compensation surveys, the director retirement plan/director split dollar agreement survey would be based on review of proxy statement and Form 10-K filings with the SEC. The SNL Executive Compensation Review is the most widely used compensation survey in the banking industry. While the SNL Executive Compensation Review identifies director and executive officer participation for a number of standard compensation arrangements, insofar as its compilation of director benefits, the SNL Executive Compensation Review only identifies the incidence of director stock options and director restricted stock grants. Armed with knowledge regarding whether or not directors participate in a director retirement plan or receive split dollar death benefits, a bank can design and finance competitive compensation benefits for directors which will attract, retain, and recruit quality directors.