Many South Dakota banks seek to diversify their loan portfolios to include commercial or real estate loans originated in other markets. Because South Dakota banks may lack the ability to originate loans themselves in areas outside of their normal geographic market, banks often use loan participations or loan broker arrangements to provide out of market diversification. While diversification in a bank’s loan portfolio makes sense in general, the practice can raise other issues for a bank to consider, including the potential for unintended legal loan limit (LLL) violations.

The Office of the Comptroller of the Currency recently issued guidance on avoiding LLL violations in programs in which a national bank purchases multiple loans to different borrowers that are all purchased from the same seller. The guidance is found in OCC Bulletin 2023-27 entitled “Loan Purchase Activities: Legal Lending Limit Guidance” that the OCC issued on August 8, 2023.[1] The Bulletin notes loans purchased from the same seller (even though they are loans to different borrowers) may be combined for lending limit purposes if the bank purchaser has recourse rights against the seller. The issue gets murky because a seller’s recourse obligations for these purposes can be either explicit or implied.

Under the OCC’s lending limit regulations, a bank’s purchase of multiple loans from the same seller will not be combined for LLL purposes if the bank does not have direct or indirect recourse to the seller (see 12 CFR § 32.2(q)(1)(iii)). Conversely, as pointed out in the OCC’s August 8, 2023 Bulletin, multiple loans purchased from the same seller will be combined for LLL purposes if the bank purchaser has direct or indirect recourse to the seller, whether that recourse is explicit or implied. As an example of implied recourse, the Bulletin points to situations “when the seller has routinely substituted or purchased loans or refilled or replenished a reserve account even when [the parties’] contract does not require those actions.” The Bulletin further notes that implied recourse can be established through the bank purchaser’s course of dealing with the seller.

Defining “Course of Dealing”

For a definition for “course of dealing” the Bulletin refers to a provision in the Uniform Commercial Code (codified in South Dakota at SDCL 57A-1-303) which defines a course of dealing “as a sequence of previous conduct between the parties … that is fairly regarded as establishing a common basis of understanding for interpreting their expressions and other conduct.” Thus, even if the parties’ transaction documents do not provide for recourse against the seller for purchased loans, those loans will be combined for assessing a bank purchaser’s LLL compliance if the parties’ “previous conduct” demonstrates that the bank purchaser looks to the seller for relief if a purchased loan goes into default.

Concerning the recourse issue and its impact on lending limits, South Dakota’s banking statutes and regulations are almost silent on whether a bank’s recourse rights against a seller of loans or participations is relevant for lending limit purposes. The only place in South Dakota’s banking statutes and regulations where the word “recourse” appears is in SDCL 51A-4-24 concerning the authority of a state bank to engage in factoring. That statute in effect provides that if a bank has recourse rights against the seller of “open accounts” that the bank purchases then the total of such accounts will be deemed to be a loan to the seller for purposes of South Dakota’s lending limit statutes.

On its face, OCC Bulletin 2023-27 applies only to national banks. However, in the authors’ experience the South Dakota Division of Banking has often referred to and applied OCC lending limit rules and policies to state banks for purposes of assessing a state bank’s compliance with South Dakota lending limit requirements. The authors are aware of at least one loan purchase program in which the Division of Banking has orally advised that all the loans purchased from that program’s seller, even though made to separate borrowers, will be combined for purposes of applying South Dakota lending limits.

Pay Close Attention

Banks should pay close attention to the details in a participation agreement to avoid regulatory issues and unintended consequences. From the participant bank’s perspective, the loan must be underwritten in accordance with the bank’s normal lending policy and the bank should not simply rely on the underwriting of the lead bank. A participant should ensure that the participation agreement obligates the lead bank to provide necessary ongoing reporting so that it can continue to monitor the loan after origination. If the selling bank is using the participation to address a lending limit issue, it should be certain that the participation agreement operates to remove the portion of the loan sold to the participant from the selling bank’s balance sheet.

One issue that has tripped up lead banks from time to time involves participations structured on a last in first out (“LIFO”) or first in first out (“FIFO”) basis. Based on current accounting guidance, LIFO and FIFO based participations do not effectively remove the portion of the loan sold from the selling bank’s books. (The guidance on loan participations issued by the South Dakota Division of Banking in 2007, noted in footnote 1, refers to accounting principles concerning a LIFO or FIFO allocation of payments on a participated loan that have been modified since the guidance was issued. Thus, in that respect, the 2007 guidance does not reflect current accounting principles and may not reflect the current thinking of the Division of Banking). Only participations structured as a sale of a proportionate or pro rata share of the entire loan, where all payments must be divided proportionately among the participants and no priority is granted among the lead bank and the participants, qualify as true sale participations.

This article appeared in The Bottom Line, Volume 3 | 2023, a publication of The Independent Community Bankers of South Dakota.

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[1] Additional Resources:

OCC Bulletin 2020-81. Credit Risk: Risk Management of Loan Purchase Activities.

South Dakota Division of Banking. (2007). Loan Participation Guidance.

Gullickson, C., DEHS (2020). OCC Combination Rules and Bank Lending Limits.