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4000 - Advisory Opinions

Acquisition and Resale of Mandatorily Convertible Capital Notes


March 11, 1986

William M. Lloyd, Regional Counsel

At a recent visitation at the *** ("Bank"), the FDIC examiner raised certain issues with the Chicago Regional Office concerning the Bank's acquisition and subsequent resales of mandatorily convertible capital notes issued by other banks in the *** Group ("group banks"). As I understand the transactions in question, the Bank is holding in its investment portfolio capital notes issued in varying amounts by at least three group banks. The Bank purchased these notes at the time of their initial offering, essentially buying those amounts not subscribed to by the general public. The Bank resells these notes to members of the public from its holdings by issuing a note certificate of the issuing bank and reissuing to itself a new note in the lower amount. In my opinion, the acquisition of the mandatorily convertible capital notes by the Bank and the subsequent resale of those notes raises issues under both section 21 of the Glass-Steagall Act (12 U.S.C. § 378) and section 23A of the Federal Reserve Act (12 U.S.C. § 371c).

Addressing first the Glass-Steagall Act issues, section 21 of that act provides, in part, that it shall be unlawful for: "any person, firm, corporation, association, business trust or other similar organization, engaged in the business of issuing, underwriting, selling or distributing. . . stocks, bonds, debentures, notes or other securities to engage at the same time to any extent whatever in the business of receiving deposits. . . ." Thus, the Bank is prohibited by section 21 from engaging in the underwriting of securities. Clearly, the capital notes of the group banks are securities within the meaning of this act. The issue, then, is whether the Bank is an underwriter of the securities. The examiner informs me that the Bank actively engages in the solicitation of buyers for the capital notes. Apparently, you initially informed the examiner that the Bank used word of mouth, mailing, lobby advertisements and letters to existing investors and shareholders to solicit these sales. You then informed the examiner that only letters to shareholders are used for solicitation. The letters are enclosed with dividend checks, make known the availability of the capital notes issued by the other group banks, and include language that recommends and encourages the purchase of the notes.

The term underwriter is defined in section 2(11) of the Securities Act of 1933 (15 U.S.C. § 77b(2)(11), in part, as follows: "the term underwriter' means any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking. . . ." In this case, the group banks are the issuers, and it is not disputed that the Bank has purchased securities from such issuers. It also appears that the Bank has acquired the securities from the issuers with an intent to resell such securities to members of the general public, and has used at least letters to shareholders in promoting the sales. It is my further understanding that your Bank has received the approval from the Commissioner's Office to buy the capital notes with the understanding that the securities would be sold prior to maturity. In my opinion, the Bank has purchased the securities from their issuers with the intent of distributing them to the public and selling them on behalf of the issuer within the definition of "underwriter" contained in section 2(11).

The purchase of the securities also raises certain questions under section 23A of the Federal Reserve Act. For purposes of this discussion, we are accepting your assertion that the group banks are affiliates. The acquisition of the securities is a "covered transaction" within the meaning of section 23A(b)(7) of that act. The issue, however, is whether the transaction is in the nature of a loan or extension of credit to the affiliate or is a purchase of assets. In either case, the percentage limitations of section 23A(b)(7) are applicable. Of course, the collateral requirements apply only if the acquisition of the capital notes is in the nature of a loan or an extension of credit to that affiliate. For reasons similar to those stated above, the acquisition of the capital notes is considered an extension of credit rather than an acquisition of assets for purposes of section 23A. That is, the purchases must be on a temporary basis and that the Bank is, in fact, actively engaged in resale activities. The Bank never intended to acquire those securities as an investment, but actively engaged in the underwriting transactions indicated above as a means of providing funds to the affiliated banks in a manner analagous to an extension of credit.

As a loan or extension of credit, the transaction must be collateralized within the requirements of section 23A(c)(1). If the capital notes are viewed as collateral, it appears that the applicable collateral restriction would be sub-paragraph (C), which requires 120% collateral coverage. As a result, these loans are in violation of the statute.

Because the Bank is engaged in an activity which would appear to be prohibited to it pursuant to section 21 of the Glass-Steagall Act and because violations of section 23A are subject to civil money penalties, the Bank should promptly inform this office of its intentions in this matter. Please call the undersigned if you have any questions concerning this letter. Safety and soundness issues relating to the transactions will be addressed separately by DBS Regional Office staff.

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