National bank had authority to acquire and hold the preferred stock of an unaffiliated company. Letter states that the bank had the authority to acquire and may continue to hold the preferred stock under its authority in 12 USC 24(7) to discount and negotiate evidences of debt.

O

Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219

Interpretive Letter #941

June 11, 2002 August 2002

12 USC 24(7)

Dear [ ]:

This responds to your request for confirmation that [ ] (“Bank”) had authority to

acquire preferred stock of [ ] (“Company”), a subsidiary of [ ], pursuant to its

authority to discount and negotiate evidences of debt. The Bank acquired the preferred stock

(“Preferred Stock”) as partial consideration for the disposition of a loan portfolio to the

Company. Based on the information and representations you provided, we conclude that the

Bank had authority to acquire and may continue to hold the Preferred Stock pursuant to its

authority to discount and negotiate evidences of debt. The Bank’s existing holdings represent

less than 5% of the Bank’s capital and surplus and are within applicable limits.

Background

The Bank recently disposed of a portfolio of loans to the Company in exchange for cash and

Preferred Stock. The Bank had negotiated to dispose of the loan portfolio for cash, but had

accepted the Company’s offer of 90% cash and 10% Preferred Stock because the cash portion of

the Company’s offer was significantly higher than other offers the Bank received.

The Preferred Stock was issued in a private placement and is rated above investment grade by

two nationally recognized statistical rating organizations. It has a limited life of 20 years and is

not otherwise redeemable at the option of the issuer. Dividend payments are cumulative with a

fixed dividend of 6.2%. Preferred Shareholders have a priority over common stockholders upon

dissolution of the corporation and have no voting rights other than those required under state law

(generally relating to the preferred shareholders’ liquidation preference rights)

limited life of 20 years and is

not otherwise redeemable at the option of the issuer. Dividend payments are cumulative with a

fixed dividend of 6.2%. Preferred Shareholders have a priority over common stockholders upon

dissolution of the corporation and have no voting rights other than those required under state law

(generally relating to the preferred shareholders’ liquidation preference rights). There is a one-

year restriction on the sale or transfer of the Preferred Stock except to the Bank’s affiliates.

After one year, the Bank may transfer the Preferred Stock to a commercial bank, finance

company, insurance company, or other financial institution or fund, that is regularly engaged in

making, purchasing or investing in loans, and has a tangible net worth in excess of $100,000,000.

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You have asked whether the Bank had authority to acquire and hold the Preferred Stock under its

authority to discount and negotiate evidences of debt.1

Discussion

A. Legal Authority to Acquire and Hold the Preferred Stock

National banks may acquire and hold preferred stock under the authority in 12 U.S.C. §

24(Seventh) to discount and negotiate evidences of debt if the preferred stock is, in substance, a

debt obligation of the issuer.

Section 24(Seventh) expressly authorizes national banks to conduct the business of banking,

including “by discounting and negotiating promissory notes, drafts, bills of exchange and other

evidences of debt.” 2 12 U.S.C. § 24(Seventh). This authority has long included the power to

acquire and hold a variety of debt and debt-like instruments, including certain instruments

denominated as securities.3

1 The OCC has permitted national banks to purchase and hold preferred stock as Type III investment securities if the

securities meet the applicable rating and marketability requirements of 12 C.F.R. § 1.2. See Interpretive Letter No.

777 (April 8, 1997), reprinted in [1997 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-204

nated as securities.3

1 The OCC has permitted national banks to purchase and hold preferred stock as Type III investment securities if the

securities meet the applicable rating and marketability requirements of 12 C.F.R. § 1.2. See Interpretive Letter No.

777 (April 8, 1997), reprinted in [1997 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-204. The OCC does

not express any view on whether the Preferred Stock, in this case, meets the marketability requirements of 12 C.F.R.

§ 1.2 or qualifies as a Type III investment security. Regardless of whether is qualifies as a Type III investment

security, however, the Preferred Stock should be reported as a security under FAS 115. In addition, the Preferred

Stock should be categorized as a security and listed in Schedule B (Securities) in the Call Report.

2 The courts have long held that the term “discount” includes purchases of notes and other evidences of debt. See,

e.g., National Bank v. Johnson, 104 U.S. 271 (1881); Steward v. Atlantic National Bank, 27 F.2d 224, 228 (9th Cir.

1928); Morris v. Third National Bank, 142 F. 25 (8th Cir. 1905); Danforth v. National State Bank of Elizabeth, 48 F.

271 (3d Cir. 1891). See also 12A Words and Phrases 285-95 (West 1954 and Supp. 1986). And negotiation is a

form of transfer, disposition or sale. Black’s Law Dictionary 934 (5th ed. 1979); 28 Words and Phrases 758-766

(West 1955 & Supp. 1986). Thus, the OCC has concluded that the authority to discount and negotiate evidences of

debt includes the authority to purchase and sell debt and debt-like instruments. See e.g., OCC Conditional Approval

No. 262, Interpretations and Actions, Dec. 1997, Vol. 10, No. 12 (“the power to discount and negotiate is the power

to purchase and sell, and purchasing and selling as principal defines underwriting and dealing”).

3 See Interpretive Letter No. 833 (July 8, 1998), reprinted in [1998 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶

81-287 (; Interpretive Letter No

s. See e.g., OCC Conditional Approval

No. 262, Interpretations and Actions, Dec. 1997, Vol. 10, No. 12 (“the power to discount and negotiate is the power

to purchase and sell, and purchasing and selling as principal defines underwriting and dealing”).

3 See Interpretive Letter No. 833 (July 8, 1998), reprinted in [1998 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶

81-287 (; Interpretive Letter No. 834, (July 8, 1998), reprinted in [1998 Transfer Binder] Fed. Banking L. Rep.

(CCH) ¶ 81-288; Interpretive Letter No. 600 (July 31, 1992), reprinted in [1992-1993 Transfer Binder] Fed.

Banking L. Rep. (CCH) ¶ 83,427; Interpretive Letter No. 182 (March 10, 1981), reprinted in [1981-1982 Transfer

Binder] Fed. Banking L. Rep. (CCH) ¶ 85,263. The OCC has sometimes referred, more broadly, to a national

bank’s “general lending authority” to purchase debt securities rather than the authority to discount and negotiate

evidences of debt. For example, the OCC approved a bank’s purchase of participation certificates that represented

interests in pools of FHA-insured Title I property improvement loans under its general lending powers. See, e.g.,

Interpretive Letter No. 579 (March 24, 1992), reprinted in [1991-1992 Transfer Binder] Fed. Banking L. Rep.

(CCH) ¶ 83,349. This reference to a bank’s general lending authority includes the authority to discount and

negotiate evidences of debt.

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For example, the OCC concluded that a national bank could acquire privately placed assets-

backed securities under its authority to negotiate evidences of debt.4 In that case, the bank had

asked whether the asset-backed securities qualified as investment securities under 12 C.F.R. Part

1. The OCC determined that the securities did not meet the marketability requirements for

investment securities, but could be purchased under the authority to negotiate evidences of debt

placed assets-

backed securities under its authority to negotiate evidences of debt.4 In that case, the bank had

asked whether the asset-backed securities qualified as investment securities under 12 C.F.R. Part

1. The OCC determined that the securities did not meet the marketability requirements for

investment securities, but could be purchased under the authority to negotiate evidences of debt.

The OCC stated that the ability of a national bank to acquire asset-backed securities is not

limited by the fact that such investments may not be eligible as investment securities.5

The OCC reached the same conclusion in a recent matter involving trust preferred securities.6

Trust preferred securities are debt-like instruments that are issued by trusts organized by banks or

bank holding companies. In a typical structure, the trust sells common securities to the

organizing bank or bank holding company and sells preferred securities to third party investors.

The proceeds of the preferred securities issuance are then used to purchase a junior subordinated

debenture from the bank or bank holding company. The bank or bank holding company

guarantees that the trust will pay its obligations with the cash it has collected from the interest

payments on the junior subordinated debt it owns.

The OCC had previously determined that, although trust preferred securities were denominated

as securities, they were, in substance, debt obligations.7 As debt obligations, the trust preferred

securities would qualify as investment securities as long as they met the applicable rating and

marketability requirements of 12 C.F.R. Part 1

the interest

payments on the junior subordinated debt it owns.

The OCC had previously determined that, although trust preferred securities were denominated

as securities, they were, in substance, debt obligations.7 As debt obligations, the trust preferred

securities would qualify as investment securities as long as they met the applicable rating and

marketability requirements of 12 C.F.R. Part 1. The OCC later concluded that national banks

could purchase trust preferred securities under the authority to discount and negotiate evidences

of debt even if they did not qualify as investment securities, because the trust preferred securities

were debt obligations.8

The OCC has considered several factors to determine whether securities with characteristics of

both debt and equity have sufficient indicia of debt to qualify as debt obligations.9 These factors

include whether the returns on the investment are fixed or based on the success of the enterprise,

4 Interpretive Letter No. 600, supra.

5 Id.

6 Interpretive Letter No. 908, reprinted in [Current Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-433 (April

23, 2001).

7 Interpretive Letter 777, supra.

8 Interpretive Letter No. 908, supra.

9 Some of these decisions addressed whether the securities would qualify as investment securities and did not

discuss the authority to discount and negotiate evidences of debt. Nonetheless, these decisions are instructive

because the OCC first had to determine whether the securities were debt obligations in order to determine whether

they qualified as investment securities. An investment security is, by definition, “a marketable debt obligation that

is not predominately speculative in nature.” 12 C.F.R. 1.2(e).

he authority to discount and negotiate evidences of debt. Nonetheless, these decisions are instructive

because the OCC first had to determine whether the securities were debt obligations in order to determine whether

they qualified as investment securities. An investment security is, by definition, “a marketable debt obligation that

is not predominately speculative in nature.” 12 C.F.R. 1.2(e).

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the voting rights of the stockholder, the obligation to pay dividends, rights of stockholders in the

event of the failure of the issuer, whether the security has a limited life and whether it is rated.10

These factors distinguish equity securities (or common stock) from debt securities. For example,

common stock provides an ownership interest and appreciation of the market value of the issuer

and dividends. In contrast, debt securities offer investors periodic interest payments, often in the

form of fixed dividend payments, and a principal payment at maturity. In addition, common

stock typically is perpetual and has broad voting rights, while debt securities can be perpetual or

limited in term and have limited voting rights. In the event of the failure of an issuer, the claims

of the common stockholders are subordinate to the holders of debt securities. Finally, rating

agencies typically do not rate equity instruments but will assign credit ratings to debt securities.

Relying on these factors, the OCC has determined that national banks may purchase preferred

stock as an investment security where the preferred stock can be properly characterized, in

substance, as a debt obligation. For example, the OCC concluded that money market preferred

stock had sufficient indicia of debt to qualify as an investment security under 12 C.F.R. Part 1.11

Like debt holders, money market preferred holders did not share in the appreciation or the profits

of the issuer, but instead were entitled to dividends determined by a formula established in the

prospectus and principal at redemption

tion. For example, the OCC concluded that money market preferred

stock had sufficient indicia of debt to qualify as an investment security under 12 C.F.R. Part 1.11

Like debt holders, money market preferred holders did not share in the appreciation or the profits

of the issuer, but instead were entitled to dividends determined by a formula established in the

prospectus and principal at redemption. Money market preferred holders also had limited voting

rights typical of debt holders. Although the money market preferred stock did not have a set

maturity date, the OCC viewed it as similar to a series of fixed maturity instruments because

dividend rates on the stock was reset every 49 days. Finally, like other debt instruments, the

money market preferred stock was given a credit rating by the rating agencies.

In addition, as noted above, the OCC has concluded that trust preferred securities are debt-like

instruments that may be purchased as investment securities or under the authority to discount and

negotiate evidences debt.12 Trust preferred securities have many characteristics typically

associated with debt obligations including fixed and cumulative dividends, limited voting rights,

and limited life.

The Preferred Stock is analogous in virtually all relevant respects to the preferred stock the OCC

has previously concluded are debt obligations and not equity.13 The Preferred Stock has

characteristics typically associated with debt obligations, such as corporate bonds and municipal

revenue bonds. For example, like debt holders, the Preferred Stockholders do not share in the

10 See e.g., Interpretive Letter 777 and Interpretive Letter No. 781, both supra.

11 See Interpretive Letter No. 781, supra (money market preferred stock closely resembles and can be properly

characterized in substance as debt).

12 See Interpretive Letter No. 777, supra (trust preferred securities are debt-like obligations) and Interpretive Letter

No

10 See e.g., Interpretive Letter 777 and Interpretive Letter No. 781, both supra.

11 See Interpretive Letter No. 781, supra (money market preferred stock closely resembles and can be properly

characterized in substance as debt).

12 See Interpretive Letter No. 777, supra (trust preferred securities are debt-like obligations) and Interpretive Letter

No. 908, supra (trust preferred securities qualify as debt obligations and may be purchased and held as loans). See

also, OCC Conditional Approval No. 262, supra (“ trust preferred securities are debt securities representing the long

term secured or unsecured debt obligations of the issuing corporation”).

13 See e.g., Interpretive Letter No. 781, Interpretive Letter No. 777 and Interpretive Letter No. 908 all supra.

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profits of the issuer, but rather receive fixed dividend payments during the term of the Preferred

and principal at redemption. Also, like holders of debt, the Preferred Stockholders do not have

authority to vote on ownership matters other than in limited situations. And claims of the

common stockholders are subordinate to the holders of the Preferred Stock upon dissolution of

the Company. In addition, like most debt, the Preferred Stock is not perpetual. It has a limited

life of 20 years. It is also given a credit rating by rating agencies, just as with debt. Thus,

because the Preferred Stock closely resembles and can be properly characterized, in substance, as

debt, the Bank may acquire and hold it under the authority to discount and negotiate evidences of

debt.

Because the Preferred Stock is, in substance, a debt obligation, the Bank’s acquisition of the

Preferred Stock does not violate the Glass-Steagall Act’s limitation on stock ownership. That

provision limits the ownership of the “stock of any corporation” unless “otherwise permitted by

law.”14 Here the preferred stock, despite its label, is not, in substance, “stock of any

corporation.”15 Functionally, it is a debt obligation

s, in substance, a debt obligation, the Bank’s acquisition of the

Preferred Stock does not violate the Glass-Steagall Act’s limitation on stock ownership. That

provision limits the ownership of the “stock of any corporation” unless “otherwise permitted by

law.”14 Here the preferred stock, despite its label, is not, in substance, “stock of any

corporation.”15 Functionally, it is a debt obligation. As a debt obligation, its acquisition is

“otherwise permitted by law.”16 Specifically, national banks may acquire the Preferred Stock

pursuant to the authority to “discount and negotiate . . . evidences of debt.”17

B. Prudential Standards and Regulatory Limits on Preferred Stock

Banks that hold debt obligations, such as the Preferred Stock, are subject to limits on the amount

of debt the bank may hold. Most debt obligations are subject to limits of 10 to 15% of the bank’s

capital and surplus. 18 Some debt obligations, such as subordinated, unsecured long-term debt

may be subject to stricter limits for safety and soundness reasons. In this case, the Preferred

Stock represents less than 5% of the Bank’s capital and surplus. 19 This amount is within the

prudential limits that the OCC would apply to such subordinated unsecured long-term debt.

The Bank also must adhere to the prudential requirements in Banking Circular No. 181 (Rev.).20

In that regard, the Bank should conduct an independent analysis to determine that the acquisition

14 12 U.S.C. § 24(Seventh).

15 Id.

16 Id.

17 Id.

18 For example, debt obligations that qualify as Type III investment securities under 12 C.F.R. Part 1 are subject to a

10% investment limit. Debt obligations that qualify as loans and other extensions of credit are generally subject to a

15% lending limit, under 12 U.S.C. § 84 and 12 C.F.R. § 32. A financed sale of assets is generally exempt from that

legal lending limit, however. See 12 C.F.R. § 32.2(k)(2)(iii)

t obligations that qualify as Type III investment securities under 12 C.F.R. Part 1 are subject to a

10% investment limit. Debt obligations that qualify as loans and other extensions of credit are generally subject to a

15% lending limit, under 12 U.S.C. § 84 and 12 C.F.R. § 32. A financed sale of assets is generally exempt from that

legal lending limit, however. See 12 C.F.R. § 32.2(k)(2)(iii).

19 The Bank acquired $105 million of preferred stock from the Company. This represents 4.64% of the Bank’s total

equity capital of $2,260,849M as of March 31, 2002.

20 See OCC Banking Circular 181 (Rev.) (August 2, 1984), reprinted in [1983-1984 Transfer Binder] Fed. Banking

L. Rep. (CCH) ¶ 63-506.

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of the Preferred Stock meets the Bank’s own internal underwriting standards. The nature and

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

Bank’s lending policies and procedures. The Bank’s acceptance of a favorable analysis of the

Preferred Stock by the issuer, a credit rating institution, or another entity does not satisfy the

need to conduct an independent credit analysis. The Bank may, however, consider analysis by

other sources as factors when independently assessing the Preferred Stock. The Bank must

maintain its analysis on an ongoing basis and must have continued access to appropriate credit

and portfolio performance data as long as it holds the Preferred Stock.

Conclusion

The Bank had authority to acquire and may hold the Preferred Stock under its authority to

discount and negotiate evidences of debt. The Bank’s existing holdings represent less than 5% of

the Bank’s capital and surplus and are within applicable limits. If you have any questions, please

contact Beth Kirby, Special Counsel, at (202) 874-5210.

Sincerely,

-signed-

Ellen Broadman

Director

Securities and Corporate Practices Division