Eagle Traders

THE ECONOMICS OF THE PRIVATE MARKET

Appendix C. Legal and Regulatory Restrictions on Bank Participation in the Private Placement Market

Commercial banks may participate in the private placement market as issuers, buyers, agents, and brokers, but they are subject to legal and regulatory restrictions in some of these activities.

Banks as Issuers

No restrictions on issuance of privately placed securities apply specifically to commercial banks or bank holding companies. Like other issuers, these entities must comply with securities laws.

Summary of Bank Powers To Buy Private Placements

Table C.1 summarizes bank powers to buy private placements, which vary with the nature of the security and the type of buyer. Briefly, and ignoring exceptions detailed below, banks may not buy privately placed equity, but they may buy private debt, so long as it is booked for regulatory purposes as a loan. Bank holding companies may buy limited amounts of equity and may buy privately placed debt without restriction.

Bank Purchases of Privately Placed Debt

Two complexities prevent a simple yes-or-no answer to the question ''May banks buy privately placed debt for their own accounts?'' ¹⁷⁸ First, regulatory authority over banks operating in the United States is divided. National banks are regulated primarily by the Office of the Comptroller of the Currency (OCC), state-chartered banks that are members of the Federal Reserve System and foreign banks are regulated by the Federal Reserve, and state-chartered nonmember banks (with FDIC insurance) by the FDIC. Statechartered banks must also comply with restrictions imposed by state authorities.

The second complication is that financial instruments that are securities for some legal and regulatory purposes may be loans for other legal and regulatory purposes.

National bank activities involving securities are subject to the Glass-Steagal Act (12 USC �24(7)) and to the investment securities regulation of the OCC (12 CFR Part 1). Glass-Steagal specifically authorizes national banks to purchase for their own account ''investment securities,'' which the OCC defines to be ''a marketable obligation in the form of a bond, note, or debenture which is commonly regarded as an investment security. [They are not] investments which are predominantly speculative in nature.'' ¹⁷⁹ To date, the OCC has taken the position that private placements are not ''marketable'' (because of the absence of a public market for such securities), and thus such securities are not eligible for purchase as ''investment securities'' by national banks.¹⁸⁰ However, they may be purchased and classified as loans for regulatory purposes, so long as normal loan underwriting procedures are followed. That is, private placements may be booked as loans so long as the creditworthiness of the borrower (issuer) is evaluated and documented. ¹⁸¹

Regulatory treatment of securities as loans is not unusual. Banks have long been permitted to classify as loans their purchases of commercial paper, which is commonly recognized as a security. The OCC has explicitly stated that the classification of an instrument as a security for the purposes of securities law does not necessarily mean it must be a security for purposes of banking law. ¹⁸²

The Federal Reserve Act makes state-chartered member banks subject to Glass-Steagal restrictions on securities activities. ¹⁸³ The Federal Reserve's practice has to date generally followed that of the OCC in matters of investment security regulation. ¹⁸⁴ Thus state-chartered member banks also may not book private placements as investment securities, but they may classify private placements as loans if proper underwriting procedures are followed. In the same vein as OCC writings on this subject, the Federal Reserve Board's Commercial Bank Examination Manual states:

Occasionally, examiners will have difficulty distinguishing between a loan and a security. Loans result from direct negotiations between a borrower and a lender. A bank will refuse to grant a loan unless the borrower agrees to its terms. A security, on the other hand, is usually acquired through a third party, a broker or dealer in securities. Most securities have standardized terms which can be compared to the terms of other market offerings. Because the terms of most loans do not lend themselves to such comparison, the average investor may not accept the terms of the lending arrangement. Thus, an individual loan cannot be regarded as a readily marketable security. ¹⁸⁵

The securities investments of state nonmember banks are subject to the restrictions of relevant state laws, rather than to those of the Glass-Steagal Act. Banks with FDIC deposit insurance (that is, almost all banks) are also subject to FDIC regulations. The FDIC has generally followed OCC practice in this area, with one possible exception, but recent legislation may lead to some departure from OCC practice. A recent amendment to the FDI Act (12 USC 1831a), which was part of the FDIC Improvement Act (FDICIA), prohibits any insured state bank from engaging as principal in any activity that is not permissible for a national bank unless the state bank meets its capital requirements and the FDIC consents. Since ''activity'' includes making any investment, an insured state bank is now able to ask the FDIC for permission to place in its investment account debt securities that do not qualify as investment securities.

The other possible departure from OCC practice involves the fact that some states grant banks authority to make ''leeway'' investments, that is, to buy limited quantities of certain securities that are otherwise ineligible. Except for securities in default, the FDIC will not criticize such investments so long as they are permitted by applicable state law, the total of all such investments does not exceed 10 percent of equity capital and surplus, and the investments have been approved by the bank's board of directors or trustees as leeway securities. ¹⁸⁶

The types of securities that qualify as leeway securities vary by state, but those acceptable to the FDIC as leeway investments are limited mainly to securities that state or local governments issue or guarantee, some of which may also qualify as private placements. We speculate that if any private placements of debt have been purchased by banks under this authority, the quantity has been insignificant.

The distinction between buying a private placement for an investment security account and a loan account has little economic meaning. ¹⁸⁷ Since due diligence similar to that in commercial loan underwriting is the norm in the private placement market, in practice commercial banks appear not to be generally restricted from purchasing private placements. One perhaps unintended effect of current regulations is possible, however. Some private placement agents have in recent years developed distribution channels that employ public security sales forces. These channels are most often used for the placements, especially Rule 144A placements, of highly rated or wellknown borrowers. Some of these channels circumscribe the ability of buyers to perform the in-depth due diligence that is normal for traditional private placements. Under current regulations, banks may be restricted from buying such placements because they may be unable to provide the underwriting documentation necessary to their classification as loans. If such restriction actually occurs, current regulations will unintentionally discourage bank investments in some higher-quality and moreliquid private placements and permit the purchase of riskier and less-liquid placements.

Bank Purchases of Privately Placed Equity

To a first approximation, national and state member banks may not purchase equity for their own accounts. The exceptions are numerous, however. Those for state member banks (regulated by the Federal Reserve) are detailed in table C.2, which is a copy of table 1 in section 203.1 of the Board's Commercial Bank Examination Manual. The manner of issue of the equity securities, public or private, is immaterial.

FDICIA extended the Glass-Steagal limitations on equity investments to state-chartered nonmember banks: Insured state banks are now generally prohibited from acquiring or retaining any equity security that is not permissible for a national bank. Some exceptions exist, however, for certain kinds of equity investments and for banks that had made such investments during a given period, provided that the FDIC does not object and a capital limitation is not breached. ¹⁸⁸

Bank Holding Company Purchases of Privately Placed Debt and Equity

Bank holding companies, which are regulated by the Federal Reserve Board under the Bank Holding Company Act of 1956, may purchase debt securities, whether publicly issued or privately placed. Regulation of equity purchases also does not regard the manner of issuance. Holding companies may purchase up to 5 percent of the voting stock of any nonbank corporation without prior Board approval, though such investments must be passive. They may purchase up to 24.9 percent of a nonbank firm's total capital, including subordinated debt and nonvoting stock; again, the investment must be passive.

Banks as Agents

Current law and regulation allows banks to act as agents for issuers of private placements, but restrictions on their activities differ somewhat depending on whether the activity is performed in a bank, in a securities affiliate of a bank holding company (section 20 subsidiary), or in another nonbank subsidiary of a bank holding company. Fein (1991) discusses the legal history of bank securities powers, which involved legal challenges by the Securities Industry Association and others. ¹⁸⁹

Agent activities have few restrictions when they are performed in a bank. ¹⁹⁰ A bank need not obtain permission to act as an agent. However, it should structure its relationships with issuers so that it acts as adviser (without power to commit the issuer formally) rather than as agent (with such power). (In this study, the word agent refers to both agents and advisers.) Issues for which national and state-chartered member banks act as agent may be placed in the bank's own accounts, in trust accounts or other managed accounts, or with other affiliates or the parent holding company (if these exist). ¹⁹¹ A bank's main obligation, and the main focus of examinations of bank private placement agent activities, is to fully disclose information about the bank's interests to all parties involved in a transaction. This disclosure permits parties to assess the risk flowing from any potential conflicts of interest on the part of the bank. In particular, but not exclusively, the bank must disclose any lending relationships with issuers or with potential or actual buyers of the securities and the nature of any compensation it will receive for assisting the transaction.

Bank holding companies wishing to serve as agents of private placements either in the holding company or in a nonbank affiliate must first obtain the Board's permission. When it is so located, the activity is subject to additional restrictions:

An issue may be placed with nonbank affiliates only up to 50 percent of the amount of the placement, and no issue may be placed with bank affiliates.
Loans that are the functional equivalents of purchasing for the account of an affiliate and loans to cover unsold portions of an issue cannot be made to issuers. Holding companies must be able to document that any credit to an issuer was extended under different terms, for different purposes, and at different times than were the securities being placed.
Loans cannot be made to the issuer to cover principal and interest payments until at least three years have passed since issuance.
Issues may not be placed with accounts managed by affiliated bank trust departments nor with other accounts advised or managed by affiliates.
No lines of credit or other guarantees may be provided to support privately placed issues advised by the affiliate. For example, no affiliate of the holding company may provide a backup line of credit to support a placement of commercial paper advised by a nonbank affiliate.
The notes for an issue must be in denominations of at least $100,000.
All lending relationships of the consolidated holding company with the issuer must be disclosed to actual and potential purchasers, and no investment advice may be provided to purchasers.
Securities may be placed only with accredited investors.
The securities may not be registered.
The issue must comply with relevant securities laws, for example, there can be no public solicitation nor offering.
When acting as agent for a private placement, section 20 subsidiaries must comply with some additional restrictions that apply to public underwritings. Non-section 20 subsidiaries need not do so.

Several foreign banks have received permission to conduct agent activities in securities subsidiaries, subject to the above restrictions, some details of which differ because of the banks' foreign status. U.S. branches of foreign banks and U.S. banks owned by foreign banks may also act as agents in the private market, in which case they are subject to the regulations of the relevant bank regulator.

These restrictions are more stringent than those faced by banks. For example, in its No Objection Letter 87-3 (March 24, 1987) and its Interpretive Letter 496 (December 18, 1989), the OCC permitted banks to act as agents in the private placement of registered securities of their holding companies or subsidiaries. Banks may provide lines of credit to issuers they advise and may place advised issues with affiliates and in trust or managed accounts, subject to guidance from regulators.

Bank Activities in the Secondary Market for Private Placements

In general, banks and non-section 20 subsidiaries may act as traders of securities, regardless of the nature of their issuance, but not as brokers or dealers. Section 20 subsidiaries may act as brokers or dealers. In practice, the ability of banks to actively trade private placements is limited because such placements must be booked as loans (as noted above) and normal loan underwriting standards apply. The requirement that analyses of creditworthiness be performed may not be a substantial hindrance in the secondary market for traditional private placements, in which most buyers intend to hold purchases for some time and for which due diligence is the norm. However, extensive credit analyses are more unusual in the Rule 144A secondary market, which operates much like the public bond market. Thus, except for section 20 subsidiaries, banks may have difficulty participating in this market.

C.1. Bank powers to buy private placements

Nature of security	Banks¹	Bank holding companies
Private debt	May purchase, but must place in loan account and follow underwriting procedures.	May purchase without restriction.
Private equity	Generally may not purchase, except for some specific types of stock.	May purchase, in limited quantities.

This table provides only a rough summary of banks' powers. Limitations on bank powers vary by chartering authority and insured status, that is, according to the identity of the regulators.

C.2. Permitted stock holdings by member banks

Type of stock	Authorizing statute and limitation
Federal Reserve Bank	Sections 2 and 9-Federal Reserve Act (12 USC 282 and 321), and Regulation 1 (12 CFR 209)-Subscription must equal 6 perent of the bank's capital and surplus, 3 percent paid in.
Safe deposit corporation	12 USC 24-15 percent of capital and surplus.
Corporation holding bank premises	Section 24A-Federal Reserve Act (12 USC 371(d))-100 percent of capital stock. Limitation includes total direct and indirect investment in bank premises in any form (e.g., loans, etc.). Maximum limitation may be exceeded with permission of the Federal Reserve Bank for state member banks and the Comptroller of the Currency for national banks.
Small business investment company	15 USC 682(b) (Section 302(b)-Small Business Investment Act of August 21, 1958)-Banks are prohibited from acquiring shares of such a corporation if, upon making the acquisition, the aggregate amount of shares in small business investment companies then held by the bank would exceed 5 percent of its capital and surplus.
Edge and Agreement corporations, and foreign banks	Sections 25 and 25(a)-Federal Reserve Act (12 USC 601 and 618)-The aggregate amount of stock held in all such corporations may not exceed 10 percent of the member bank's capital and surplus. Also, the member bank must possess a capital and surplus of $1 million or more prior to acquiring investments pursuant to Section 25.
Banking Service Corporation	12 USC 1861 and 1862 (Section 2(a) of the Bank Service Corporation Act of 1958)-10 percent of capital and surplus. Limitation includes total direct and indirect investment in any form. No insured bank may invest more than 5 percent of its total assets.
Federal National Mortgage Association	12 USC 1718(f)(Section 303(f), National Housing Act of 1934)-No limit.
Bank's own stock	12 USC 83-Shares of the bank's own stock may not be acquired or taken as security for loans, except as necessary to prevent loss from a debt previously contracted in good faith. Stock, so acquired, must be disposed of with six months of the date of acquisition.
Corporate stock acquired through debts previously contracted (DPC)	Case law has established that stock of any corporation may be acquired to prevent loss from a debt previously contracted in good faith. See Oppenheimer v. Harriman National Bank & Trust Co. of the City of New York, 301 US 206 (1937). However, if the stock is not disposed of within a reasonable time period, it loses its status as a DPC transaction and becomes a prohibited holding under 12 USC 24(7).
Operations subsidiaries	Permitted if the subsidiary is to perform, at locations at which the bank is authorized to engage in business, functions that the bank is empowered to perform directly (12 CFR 250.141).
State Housing Corporation incorporated in the state in which the bank is located	12 USC 24-5 percent of its capital stock, paid in and unimpaired, plus 5 percent of its unimpaired surplus fund when considered together with loans and commitments made to the corporation.
Agricultural Credit Corporation	12 USC 24-20 percent of capital and surplus unless the bank owns over 80 percent. No limit if the bank owns 80 percent or more.
Government National Mortgage Association	12 USC 24-No limit.
Student Loan Marketing Association	12 USC 24-No limit.
Bankers' banks	12 USC 24-10 percent of capital stock and paid in and unimpaired surplus. Bankers' bank must be insured by the FDIC, owned exclusively by depository institutions, and engaged solely in providing banking services to other depository institutions and their officers, directors or employees. Ownership shall not result in any bank's acquiring more than 5 percent of any class of voting securities of the bankers' bank.

Source. Commercial Bank Examination Manual, Section 203.1 (March, 1984), pp. 2-3.

Banks may buy private placements for trust and other managed accounts, so long as they follow policies to ensure avoidance of conflicts of interest.
12 CFR � 1.3(b).
The OCC Handbook for National Bank Examiners (� 203.1, p. 1) states that a security ''is marketable if it may be sold quickly at a price commensurate with its yield and quality.'' Based solely on this definition, many privately placed securities would qualify as marketable, but in practice the OCC does not consider them such.
Loan-to-one-borrower limits must also be observed.
See especially OCC Interpretive Letter, No. 329 (3/4/85). Also see the passages, ''For purposes of banking law, an [instrument] may be a loan, a security or an investment security. Those distinctions are made on a case-by-case basis'' (OCC Interpretive Letter, No. 182 [(3/10/81]), and ''credit analysis and risk are what typifies [a] transaction as a banking practice'' (OCC Interpretive Letter, No. 338 [5/2/85]).
12 USC � 335.
See Fein (1991), p. 4-3, for a discussion of a case in which the Federal Reserve did not agree with the OCC.
Section 203.1, p. 1 (1984 edition).
See the FDIC's DOS Manual of Examination Policies, Revision 9-91, p. 3.2-13. See also Fein (1991), p. 4-15.
Different limits on volume of loans to one borrower do apply, however, for national and state-chartered member banks. The limit for loans is 15 percent of capital and surplus, whereas that for securities is 10 percent. Insured state nonmember banks are not subject to any federal loan-to-one-borrower limit, and limits imposed by states vary. Thus a requirement that private placements be booked as loans does not impose a more stringent limit under federal guidelines but may do so under some state guidelines.
See FDIC rule adopted October 27, 1992.
See OCC Interpretive Letter, No. 32 (December 9, 1977) for a relatively early explicit ruling that banks may act as agents.
OCC Interpretive Letter, No. 463 (December 27, 1988) states that ''national banks may use an operating subsidiary to conduct any activity which is permissible for the bank,'' though the letter also notes that restrictions flowing from bank holding company law may apply. If no holding company restrictions apply, an operating subsidiary faces the same (minimal) restrictions on private placement agent activities that a bank does.
The FDIC strongly discourages such purchases: ''Policy constraints should prohibit placing private issues with funds that the bank manages in a fiduciary capacity, especially when the issuer is a bank loan customer.'' DOS Manual of Examination Policies, Revision 9-91, section 3.2, p. 26.

Appendix D. Historical Date on Issuance of Private Debt

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