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4000 - Advisory Opinions

Bank's Open Market Purchase of Subordinated Debt Issued by Its Parent Holding Company Is Subject to Lending Limits of §23A of the Federal Reserve Act


November 27, 1990

Gerald J. Gervino, Senior Attorney

The Legal Division has been asked to provide an opinion with respect to the subject bank's ("Bank") open market purchases of outstanding subordinated debt issued by its parent holding company ("Holding Company") and the terms upon which that debt was exchanged, by mutual cancellation, for the subordinated debt of the bank held by the holding company.

In 1987, the holding company issued $*** million in 7 5/8% subordinated notes. The net proceeds or the offering ($*** million) were downstreamed to the bank through the holding company's purchase of a new issue of the bank's 8% subordinated debt in the amount of $*** million. Subsequently, the price of the holding company's 7 5/8% notes declined in the secondary market.

In order to retire its debt at a discount, the holding company influenced the bank to purchase the debt because it did not have enough cash to effect the transaction. We understand that the bank did not submit offers to purchase debt in the market, but instead responded to offers of sale generally initiated by professional broker/dealers in securities. The bank purchased the debt for its own account, rather than as agent for the holding company or anyone else. The bank purchased the debt in a number of transactions from 1988 until June of 1990.

After an accumulation of several transactions, the bank would engage in a mutual forgiveness transaction with the holding company in which the bank transfers holding company debt to the holding company for retirement at an aggregate profit of $*** million on the books of the holding company, while the holding company forgives the bank's debt to it on an out-of-pocket basis, which does not recognize the above profit. Thus, the bank supplied the cash to effect a transaction profitable to the holding company, assumed at least some market risk by purchasing for its own account, and yet was denied any share of the profit that would benefit its parent holding company.

The bank has conceded that it was required to obtain written FDIC consent prior to each retirement of its subordinated debt. Your staff feels the transactions otherwise violate §23B of the Federal Reserve Act, 12 U.S.C. §371c--1. ("§23B").

The bank's purchases of the subordinated debt of the holding company are "covered transactions" under ¶(b)(7)(B) of §23A of the Federal Reserve Act. ("§23A"). Thus, the lending limits and other proscriptions of §23A(a) would apply.

The bank transferred its affiliate's own debt from the bank's portfolio to the affiliate at cost, without regard to the known profit to the affiliate and without regard to the value added by the bank in the form of a cash outlay and an assumption of market risk. These transfers are not the sort of transactions that can be considered on terms comparable to arms length transactions with unaffiliated parties. They involve sales of assets to the affiliate which are transactions covered under §23B(a)(2)(B). The transactions appear to violate §23B of the Federal Reserve Act.

Since the affiliate appears to equitably owe the bank an amount that is equal to the differential in the two bookings, characterized as the holding company profit above, the amount appears to be an extension of credit by the bank to its affiliate under §23A of the Federal Reserve Act and should be recorded as a loan subject to the lending limits and collateral requirements of §23A of the Federal Reserve Act. For a similar situation, see FDIC Statement of Policy, "Income Tax Remittance by Banks to Holding Company Affiliates", 43 Federal Register 22241 (May 24, 1978), reprinted in FDIC "Manual" at 5045.

If you have any further questions, please write or call me at (202) 898-3723.

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