Letter permits national banks to purchase for their own account interests in a privately offered investment fund that would invest in high-yield loans. (04/03/97)

Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219

Interpretive Letter #779

April 3, 1997

May 1997

12 U.S.C. 24(7)

[ ]

[ ]

[ ]

[ ]

Dear [ ]:

This is in response to your letter requesting an opinion from the Office of the Comptroller of

the Currency that national banks may acquire for their own account beneficial interests in a

privately offered investment fund that would invest in loans. We conclude that national banks

may acquire such interests as securities, subject to a 5 percent aggregate investment limit and

safe and sound banking practices, or as loan participations, subject to the requirements of

Banking Circular No. 181 (Rev.) (August 2, 1984) (“BC-181").

Background

[ ] (“ ”) proposes to establish a fund that would invest solely in loans.

Most of the loans would be high-yield, i.e., their interest rate would reflect a large spread

above market rates due to their credit quality. [ ] (“ ”), a

department within [ ], would manage the Fund. The Fund would have capitalization of

approximately $630 million at its inception, of which approximately $150 million would be

provided by national and state-chartered banks, insurance companies, and other persons that

qualify as “accredited investors” under the federal securities laws. The remaining $480

million in capitalization would come from the contribution of the high-yield loan portfolio

currently managed by [ ]. In addition, [ ] has committed to participate in the future in

additional loans originated or purchased by the Fund ($120 million). The minimum

investment in the Fund would be $16 million. Because interests in the Fund would be sold

through private placements, they would qualify for an exemption from registration under

section 4(2) of the Securities Act of 1933, 15 U.S.C. § 77d(2)

]. In addition, [ ] has committed to participate in the future in

additional loans originated or purchased by the Fund ($120 million). The minimum

investment in the Fund would be $16 million. Because interests in the Fund would be sold

through private placements, they would qualify for an exemption from registration under

section 4(2) of the Securities Act of 1933, 15 U.S.C. § 77d(2). The Fund would not be

subject to registration under the Investment Company Act of 1940, as it would have 100 or

fewer investors. See 15 U.S.C. § 80a-3(c)(1).

The Fund would be organized as a Delaware business trust. [ ] would be the Fund’s

managing co-trustee and a Delaware-chartered bank affiliate would be the non-managing co-

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trustee. The Fund’s governing instrument, the Business Trust Agreement (“Agreement”),

would provide that, upon dissolution of the Fund, each beneficial owner would receive a

dollar amount equal to its pro rata interest in the Fund’s net assets. The Agreement would

further provide that all net cumulative profits of the Fund be allocated to investors pro rata on

the basis of each investor’s capital account until all investors receive a preferential

compounded annual return (equal to a specified number of basis points in excess of the

London Interbank Offered Rate). If there were any profits in addition to the preferential

compounded annual return, [ ] would receive as a “special allocation” 20 percent of those

excess profits; the remaining 80 percent of any additional profits above the preferential return

would be allocated among the other investors pro rata on the basis of their capital accounts.

The Agreement would limit the Fund’s activities to participation in primary and secondary

loan markets. The Agreement would subject the Fund to supervision and examination by the

OCC, the Board of Governors of the Federal Reserve System, and relevant state banking

regulators

above the preferential return

would be allocated among the other investors pro rata on the basis of their capital accounts.

The Agreement would limit the Fund’s activities to participation in primary and secondary

loan markets. The Agreement would subject the Fund to supervision and examination by the

OCC, the Board of Governors of the Federal Reserve System, and relevant state banking

regulators. Investors in the Fund would be shielded from personal liability for the acts and

obligations of the Fund since their liability as owners of beneficial interests in the Fund would

be limited to the value of those interests.

The Fund’s portfolio would hold loans from a variety of industries, including automotive,

telephone, manufacturing, and health services. The Fund would invest no more than 10

percent of its portfolio in loans to any one business sector. The Fund would conduct monthly

valuations of its loans at market value using third-party pricing sources. In the event it is not

possible to determine market value, the Investment Manager would value loans at the lower

of cost or fair value.

Banks investing in the Fund would receive information regarding the composition, credit

quality, and performance of the loans in the Fund’s portfolio. Banks would also be able to

consult with [ ] concerning the Fund’s investment decision-making. This information

would include a list of each loan held in the Fund as of a specified date, a summary of the

principal terms of each loan, the loan’s credit rating, and information about the Fund’s credit

underwriting standards. On a quarterly basis, investors would receive information about the

Fund’s performance and changes in its composition.

Investors could liquidate their Fund holdings on a quarterly basis and would be required to

provide at least 30 days prior notice of any redemption. Redemptions would be paid in an

amount based on the market value of the Fund’s portfolio as of the redemption date

ng standards. On a quarterly basis, investors would receive information about the

Fund’s performance and changes in its composition.

Investors could liquidate their Fund holdings on a quarterly basis and would be required to

provide at least 30 days prior notice of any redemption. Redemptions would be paid in an

amount based on the market value of the Fund’s portfolio as of the redemption date. During

the first 18 months of the Fund’s operations, quarterly redemptions would be subject to a

“withdrawal fee”. The amount of this fee would decrease over time. The organizers of the

Fund have not yet established firm withdrawal fees but you state that the fee may be equal to

3 percent of the amount of the redemption during the first 6-month period, 2 percent during

the second six-month period, and 1 percent during the third such period. Investors also would

have the option of selling their interests to outside parties, subject to the consent of the

managing trustee.

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Discussion

National Bank Authority to Purchase Investment Securities

National banks may purchase investment securities subject to the limits of 12 U.S.C. §

24(Seventh) and 12 C.F.R. Part 1. The OCC defines “investment security” as a “marketable

debt obligation that is not predominantly speculative in nature.” 12 C.F.R. § 1.2(e). A

security is not “predominantly speculative in nature if it is rated investment grade.” When a

security is not rated, it must be the credit equivalent of one that is rated investment grade. Id.

The term “marketable” is defined to include a security that “[c]an be sold with reasonable

promptness at a price that corresponds reasonably to its fair value.” 12 C.F.R. § 1.2(f)(4)

C.F.R. § 1.2(e). A

security is not “predominantly speculative in nature if it is rated investment grade.” When a

security is not rated, it must be the credit equivalent of one that is rated investment grade. Id.

The term “marketable” is defined to include a security that “[c]an be sold with reasonable

promptness at a price that corresponds reasonably to its fair value.” 12 C.F.R. § 1.2(f)(4).

The OCC, however, also states in its regulations that, notwithstanding the definitions of

“investment security” and “investment grade”, “a national bank may treat a debt security as

an investment security for purposes of [Part 1] if the bank concludes, on the basis of estimates

that the bank reasonably believes are reliable, that the obligor will be able to satisfy its

obligations under that security, and the bank believes that the security may be sold with

reasonable promptness at a price that corresponds reasonably to its fair value.” 12 C.F.R. §

1.3(i)(1). Such securities are subject to a 5 percent aggregate investment limit. Id. at §

1.3(i)(2). Banks purchasing securities permitted under Part 1 must adhere to safe and sound

banking practices and consider, as appropriate, interest rate, credit, liquidity, price, foreign

exchange, transaction, compliance, strategic, and reputation risk. See 12 C.F.R. § 1.5(a).

The OCC permits national banks to purchase for their own accounts investment company

shares, provided that the investment company’s portfolio consists exclusively of assets that a

national bank could purchase directly. 12 C.F.R. § 1.3(h)(1). The OCC additionally may

permit a national bank to invest in an entity that is exempt from registration as an investment

company, provided that the portfolio of the company consists exclusively of assets that a

national bank may purchase and sell for its own account. 12 C.F.R. § 1.3(h)(2). The OCC

has permitted national banks to invest in limited partnerships and unregistered investment

companies. See Interpretive Letter No. 687 (Sept

l bank to invest in an entity that is exempt from registration as an investment

company, provided that the portfolio of the company consists exclusively of assets that a

national bank may purchase and sell for its own account. 12 C.F.R. § 1.3(h)(2). The OCC

has permitted national banks to invest in limited partnerships and unregistered investment

companies. See Interpretive Letter No. 687 (Sept. 5, 1995), reprinted in [1995 - 1996

Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-002; Interpretive Letter No. 617 (March 4,

1993), reprinted in [1992 - 1993 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 83,457;

Interpretive Letter No. 435 (June 30, 1988), reprinted in [1988 - 1989 Transfer Binder] Fed.

Banking L. Rep. (CCH) ¶ 85,659.

A crucial factor in the OCC’s regulations on investment in investment company shares and in

its prior interpretations is whether the investment company’s underlying assets consist of

bank-eligible investments. Among the activities that make up the business of banking are the

discounting and negotiating of promissory notes, drafts, bills of exchange, and other

evidences of debt, loaning money on personal security, and obtaining, issuing, and circulating

notes. See 12 U.S.C. § 24(Seventh). Those powers are merely illustrative, however, and the

list of bank powers contained in section 24(Seventh) does not constitute the full scope of the

“business of banking”. See Nations Bank v. Variable Annuity Life Insurance Company, 513

bills of exchange, and other

evidences of debt, loaning money on personal security, and obtaining, issuing, and circulating

notes. See 12 U.S.C. § 24(Seventh). Those powers are merely illustrative, however, and the

list of bank powers contained in section 24(Seventh) does not constitute the full scope of the

“business of banking”. See Nations Bank v. Variable Annuity Life Insurance Company, 513

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U.S. 251, ___, 115 S. Ct. 810, ___, 130 L. Ed. 2d 740, 749 (1995). National banking law

limits the amount of total loans and extensions of credit by a national bank to a person that are

not secured by certain specified collateral to 15 percent of the bank’s capital and surplus. 12

U.S.C. § 84.

The OCC has issued guidance on national bank purchases of “junk bonds”. See Banking

Bulletin 85-12 (May 31, 1985). The OCC defines a “junk bond” as “a speculative security

with limited marketability characteristics.” Id. Generally, the OCC has barred purchases of

junk bonds, stating that “[c]orporate debt securities used to finance corporate takeovers are

generally considered to be predominantly speculative with limited marketability.” Id. The

OCC has, however, approved national bank purchases of sub-investment grade bonds in

several contexts. See, e.g., Interpretive Letter No. 703 (January 25, 1996), reprinted in [1995

- 1996 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-018 (purchase of unrated

municipal revenue bonds to finance community development housing projects); Interpretive

Letter No. 506 (Oct. 31, 1989), reprinted in [1990 - 1991 Transfer Binder] Fed. Banking L.

Rep. (CCH) ¶ 83,204 (purchase of bonds as part of developing country debt restructuring

program); Interpretive Letter No. 470 (Feb. 1, 1989), reprinted in [1988 - 1989 Transfer

Binder] Fed. Banking L. Rep. (CCH) ¶ 85,694 (purchase of Brazilian Investment Bonds as

part of developing country debt restructuring program)

. 506 (Oct. 31, 1989), reprinted in [1990 - 1991 Transfer Binder] Fed. Banking L.

Rep. (CCH) ¶ 83,204 (purchase of bonds as part of developing country debt restructuring

program); Interpretive Letter No. 470 (Feb. 1, 1989), reprinted in [1988 - 1989 Transfer

Binder] Fed. Banking L. Rep. (CCH) ¶ 85,694 (purchase of Brazilian Investment Bonds as

part of developing country debt restructuring program).

National Bank Authority to Purchase Loan Participations

The OCC has issued extensive guidance on national bank purchases of loans and loan

participations. See BC-181. The OCC requires banks to implement “satisfactory controls”

over loan participations, including: 1) written lending policies and procedures governing those

transactions; 2) an independent analysis of credit quality by the purchasing bank; 3)

agreement by the obligor to make full credit information available to the selling bank; 4)

agreement by the selling bank to provide available information on the obligor to the

purchaser; and 5) written documentation of recourse arrangements outlining the rights and

obligations of each party. Id. at 2. BC-181 notes that, “[t]o make a prudent credit decision, a

purchaser conducts an independent credit analysis to satisfy itself that a loan, loan

participation, or loan portfolio is a credit which it would make directly. The nature and extent

of the independent analysis is a function of the type of transaction at issue and the purchaser’s

lending policies and procedures.” Id. at 3. BC-181 also states that “[t]he acceptance by a

purchaser of a favorable analysis of a loan issued by the seller, a credit rating institution, or

another entity does not satisfy the need to conduct an independent credit analysis. A prudent

purchaser may, however, consider such analysis obtained from the seller and other sources as

factors when independently assessing a loan.” Id

res.” Id. at 3. BC-181 also states that “[t]he acceptance by a

purchaser of a favorable analysis of a loan issued by the seller, a credit rating institution, or

another entity does not satisfy the need to conduct an independent credit analysis. A prudent

purchaser may, however, consider such analysis obtained from the seller and other sources as

factors when independently assessing a loan.” Id.

Purchases of Interests in the Fund

National banks may purchase interests in the Fund as securities, subject to a 5 percent

aggregate investment limit, or as loan participations. Part 1 provides for national bank

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Banking Bulletin 85-12 does not apply to this analysis as it addresses “junk bonds”

1

issued to finance corporate take-overs. The high-yield loans in the Fund do not appear to be

used for those purposes and therefore would not fall within the scope of that bulletin.

investments in unregistered investment companies so long as the underlying instruments in

the portfolio are permissible investments for national banks. Part 1 does not require that the

underlying assets of investment companies be limited to instruments labeled “securities”. 12

C.F.R. § 1.3(h); Interpretive Letter No. 687, supra. Making loans is part of the business of

banking, and national banks may hold shares of investment companies that invest in loans.

See 12 U.S.C. § 24(Seventh).

Part 1 requires that an investment security be rated investment grade or the credit equivalent

thereof. 12 C.F.R. § 1.2(e). Interests in the Fund would not qualify under Part 1 as

“investment securities” if the credit quality of a portfolio consisting of high-yield loans were

below investment grade

anks may hold shares of investment companies that invest in loans.

See 12 U.S.C. § 24(Seventh).

Part 1 requires that an investment security be rated investment grade or the credit equivalent

thereof. 12 C.F.R. § 1.2(e). Interests in the Fund would not qualify under Part 1 as

“investment securities” if the credit quality of a portfolio consisting of high-yield loans were

below investment grade. Even if interests in the Fund do not qualify as “investment

securities”, however, national banks may purchase limited quantities of interests in the Fund if

they are able to conclude: 1) that the obligor could satisfy its obligations under the security

(based on “reliable estimates”); and 2) that the security could be sold with reasonable

promptness at a price that corresponds reasonably to its fair value. See 12 C.F.R. § 1.3(i).

Under that standard, the OCC previously has permitted national banks to hold bonds to

finance community development projects whose standards did not meet the credit quality

requirements for investment securities. See Interpretive Letter No. 703, supra. The OCC

concluded that national banks could purchase those instruments in an aggregate amount up to

5 percent of their capital and surplus.

In the instant situation, national banks would need to demonstrate that, due to the Fund’s

diversification and its investment standards, the Fund would perform in a manner consistent

with the reliable estimates standard. That determination would require an analysis of the

performance of the Fund’s loans. The Fund’s diversification should help ensure its overall

performance. Investors in the Fund also should be able to sell their holdings with “reasonable

promptness” at a “price that corresponds reasonably” to their fair value since redemptions

could be made quarterly based on the interests’ market value at the time of redemption.

1

Moreover, investors would be able to sell their interests to third parties, with the consent of

the managing trustee, at any time

ance. Investors in the Fund also should be able to sell their holdings with “reasonable

promptness” at a “price that corresponds reasonably” to their fair value since redemptions

could be made quarterly based on the interests’ market value at the time of redemption.

1

Moreover, investors would be able to sell their interests to third parties, with the consent of

the managing trustee, at any time. National banks also would need to consider risk factors

enumerated in Part 1, such as liquidity risk, credit risk, compliance risk, and reputation risk,

and satisfy themselves that they can manage such risks and that the investment is appropriate

for them. See 12 C.F.R. § 1.5(a), supra.

In addition to purchasing interests in the Fund as securities under Part 1, national banks also

may purchase such interests as loans or loan participations. See Interpretive Letter No. 506,

supra. In order to rely on this authority, national banks would need to have sufficient

information available to them to make the independent credit analysis required by BC-181.

The nature and extent of the required independent credit analysis is a function of the

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particular transaction. Id. at 3. Banks investing in the Fund would receive data from [

] on the Fund’s underwriting standards, and the principal terms, credit quality, and

performance of loans in the Fund’s portfolio. Banks would also be able to consult with [

] on a continuous basis to evaluate the Fund’s investment strategy and obtain information

on the Fund’s performance and composition. Rather than a full credit analysis of every

underlying investment, national banks should be able to satisfy the requirements of BC-181

through an independent analysis of the performance information provided by the Fund and

then by a quarterly review of the loans’ performance data and credit ratings

te the Fund’s investment strategy and obtain information

on the Fund’s performance and composition. Rather than a full credit analysis of every

underlying investment, national banks should be able to satisfy the requirements of BC-181

through an independent analysis of the performance information provided by the Fund and

then by a quarterly review of the loans’ performance data and credit ratings.

Conclusion

National banks may purchase interests in the Fund either as securities under the “reliable

estimates” standard of Part 1, subject to a 5 percent aggregate investment limit, or as loan

participations, subject to a 15 percent limit. Investments made under Part 1 are subject to the

prudential considerations set forth in the rule. National banks contemplating investment in

the Fund through the purchase of interests as loan participations should undertake an

independent credit analysis as discussed above and evaluate whether the Fund’s investment

strategy and portfolio are consistent with their credit underwriting standards. If you have any

questions, please do not hesitate to contact me at (202) 874-5210.

Sincerely,

/s/

Lee Walzer

Senior Attorney

Securities and Corporate Practices Division