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