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https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Collection: Paul A. Volcker Papers Call Number: MC279  Box 28  Preferred Citation: Junk Bonds, 1985-1986; Paul A. Volcker Papers, Box 28; Public Policy Papers, Department of Rare Books and Special Collections, Princeton University Library Find it online: http://findingaids.princeton.edu/collections/MC279/c197 and fraser.sdouisfed.org/archival/5297  The digitization ofthis collection was made possible by the Federal Reserve Bank of St. Louis. From the collections of the Seeley G. Mudd Manuscript Library, Princeton, NJ These documents can only be used for educational and research purposes ("fair use") as per United States copyright law. By accessing this file, all users agree that their use falls within fair use as defined by the copyright law of the United States. 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Mudd Manuscript Library 65 Olden Street Princeton, NJ 08540 609-258-6345 609-258-3385 (fax) m udcl@princeton.edu   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  U.S. Department of Justice  Antitrust Division  Office of the Assistant Attorney General  Washington, D.C. 20530  January 7, 1986  Mr. Michael Bradfield Federal Reserve System Marriner S. Eccles Federal Reserve Board Building Constitution Avenue, N.W. Washington, D.C. 20551 Dear Mr. Bradfield: On behalf of the Treasury and Justice Departments, I want to thank you for providing our staffs with the opportunity to inspect your proposed final "interpretation" of Regulation G relating to Purchase of Debt Securities to Finance Corporate Takeovers. As you know, we had only a limited opportunity to read the 54-page proposed document in your offices and were not provided with a copy to review more fully. We also understand the draft we reviewed was subject to additional revisions. Our views, therefore, as summarized below are necessarily preliminary, and we expect to make a more thorough assessment of the proposal after it is made available to us. In general, while we find the revised "interpretation" to be less objectionable than the proposal issued on December 6, we continue to believe that it is unwarranted and unwise and that it appears to be a legislative, rather than an interpretative, rule. You have addressed several of the adverse comments submitted in response to the original proposal. First, the limitation of the "interpretation" to certain specific fact situations appears to limit the scope of the original proposal and to reduce its ambiguity. Second, the revised "interpretation" will not reverse years of precedent holding that public offerings are not covered by Regulation G. Third, the revised "interpretation" makes clear that it will not change the current application of Regulation G to credit-financed acquisitions by operating companies, even when their assets, income, or net worth are considerably less than the amount of credit raised to finance the acquisition.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  MIK  Finally, we note that, by excluding circumstances where there is a merger agreement or where there is a short form statutory merger, you have limited the application of Regulation G to credit-financed acquisitions by shell corporations; however, we are concerned that this revision further illustrates the underlying bias of the "interpretation" against hostile takeovers. While you have addressed some of our concerns with your original proposal, we cannot support the proposed "interpretation", even as redrafted. First, we continue to believe that there is simply no need for regulation in this area. Indeed, nowhere in the 54 pages of the proposed document that we read does the Board identify the benefits of the "interpretation" or explain its consistency with the congressional purposes underlying Section 7 of the Securities and Exchange Act of 1934. Second, we are concerned with certain ambiguities that remain in the Board's proposal. In the "interpretation", the statement is made that a shell corporation is one that has "virtually no assets", while an operating corporation is described as a firm with "substantial non-margin assets." There is a significant middle ground between these two definitions, and it is unclear precisely where the margin requirements would and would not apply. Our quick review of the draft also identified several portions of the "interpretation" relating to shell company debt that are very troubling. Much of the proposed document's cS mmentary is based on the premise that lenders rely on margin stock to secure debt issued by a shell because there may be a signcant delay between the time the debt is issued and the time the target is actually acquired. This premise, however, appears to be based on but a single recent transaction. The substantial cost resulting from the erpretation's" I isruption of the market for corporate control cannot be justified by the mere possibility that in a small percentage of the cases to which the erpretation" will apply there might be a significant delay once the lenders are at risk. I again stress my concern that our evaluation is necessarily preliminary because of the limited time and restricted access available to us for review of the revised   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  2  "interpretation." We, therefore, intend to conduct a more comprehensive review when the revised proposal is made available to us and to the federal agencies that were not afforded an opportunity to inspect this revision.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Sincerely,  Douglas H. Ginsburg Assistant Attorney General  3  BOARD  OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  =M6.  TO:  Board of Governors  DATE:  Legal Division Division of Supervision and Regulation  FROM:  Federal  Attached  for  Register  Notice  draft  explains  analysis  of  its  the  SUBJECT: Final interpretation concerning application of Regulation G to certain debt securities issued to finance corporate takeovers  consideration  the  the  of  rule  in  coverage.  Board  is  a  draft  interpretation  public comment on  proposed  scope  by  concerning  Regulation G proposed for  January 7, 1985  December 6.  detail, Based  including  on  the  comments, a number of changes have been proposed  of The an  public  in the draft  Notice, which are explained in the Notice. The  draft  public comments and  also contains  a  full exposition  an analysis of these comments.  of  the  Finally,  the draft reviews the issue of whether the Board may adopt the proposed  interpretative  rulemaking  procedures, as  rule  without  well as  the  following  informal  applicability  of  the  proposed interpretative rule to existing financing arrangements. For  the reasons that are carefully developed  draft Notice, the staff recommends that the interpretative rule.  Attachments   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board  in  adopt  the the  DRAFT  FEDERAL RESERVE SYSTEM 12 C.F.R. Part 207  [Regulation G; Docket No. R-0562]  Securities Credit by Persons Other Than Banks, Brokers, or Dealers; Purchase of Debt Securities To Finance Corporate Takeovers  AGENCY:  Board of Governors of the Federal Reserve System.  ACTION:  Final interpretative rule.  SUMMARY:  In  response  concerning  the  Regulation  G  acquisition corporate  questions  applicability to  of  to  debt  the  takeover  interpretative rule  of  the  securities  margin  stock  attempt,  the  interpreting  directed margin  issued of  a  Board the  to  Board  requirements finance  to  target has  the  company  issued  a  in  the in  a  final  term "indirectly secured"  in the margin rules to apply to a limited class of transactions used  to  finance  corporate  takeovers.  securities at issue clearly purchased  by  the  debt  involve "purpose credit" and  persons who may  Regulation G and  Because  become  "lenders" as defined  typically are not directly secured  are in  by margin  stock, the margin requirements apply if the debt securities are "indirectly secured" by margin stock. The interpretation view  that debt securities  provides that the Board issued  by  a  is of the  shell corporation  to  finance the acquisition of the margin stock of a target company   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -2-  are indirectly secured by the margin stock for purposes of the restrictions on shell  would  lending  have  in  the  virtually  no  margin  regulations.  business  significant business function other  Such  operations,  than  a  no  to acquire and  hold  the shares of the target company, and substantially no assets or cash flow to support the credit other than the margin stock that it has acquired or intends to acquire. The  presumption  that  the  debt  securities  are  indirectly secured by margin stock would not apply if there is specific evidence assets  other  than  that lenders could margin  in  good  faith  stock  as  collateral,  guaranty of the debt securities  by  the  parent  company  or  another  company  that  non -margin stock assets or cash flow. also not apply acquiring and  if  there  is a  merger  shell has  rely on  such  as  corporation's substantial  This presumption agreement  target companies entered  between  into at the  In  would the  time  commitment is made to purchase the debt securities or event before the loan funds are advanced.  a  the  in any  addition,  the  presumption would not apply if the obligation of the purchasers of  the  debt  corporation  securities  to  is contingent on  advance  funds  to  the  shell  the shell's acquisition of  the  minimum number of shares necessary under applicable state law to effect a merger between the acquiring and  target companies  without the approval of either the shareholders or directors of the target company.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Finally, the interpretation also provides  -3-  that the Board does not presume debt securities, issued operating  company  with  substantial  assets  or  finance the acquisition of margin stock of a  cash  by an  flow  to  target company,  are indirectly secured by margin stock and thus subject to the restrictions on margin lending in Regulation G.  EFFECTIVE DATE:  FOR  FURTHER  Immediately.  INFORMATION  CONTACT:  Laura  Homer,  Securities  Credit Officer, Division of Banking Supervision and Regulation, (202) 452-2781; or  James Michaels, Attorney, Legal Division,  (202) 452-3582.  SUPPLEMENTARY Exchange  Act  preventing  INFORMATION: 1934  of  the  Section  provides  excessive  use  carrying of securities, the  that  7  of  the  Securities  "[f]or  the  purpose  the  purchase  of credit for Board  . shall .  of or  . prescribe  rules and regulations with respect to the amount of credit that may  be  initially extended  security .  subsequently maintained  and  15 U.S.C. § 78g(a).  on  any  The Board's Regulation G,  issued pursuant to this authority, governs credit extended by a lender  that is  provides purpose  that of  not a no  buying  such or  bank  or  lender  broker/dealer.  shall  carrying  credit"), secured directly or   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  a  a  extend  margin  Regulation G  credit  stock  for  the  ("purpose  indirectly by margin stock  in  an  •  -4-  amount that exceeds the securing further stock  the  1/ loan.  provides  that  maximum 12  the  loan  C.F.R.  value of the collateral  § 207.3(b).  maximum  loan  value  is 50 percent of its current market  Regulation G of any  value.  margin  12 C.F.R.  § 207.7(a).  TABLE OF CONTENTS:  I.  BACKGROUND  II.  BASIS OF THE INTERPRETATIVE RULE  III.  A.  The Interpretative Rule  B.  Rationale for the Interpretative Rule  C.  Lenders' Reliance on Margin Stock  D.  Practical Restriction on Disposition  COVERAGE OF INTERPRETATIVE RULE A.  Limited Scope of Coverage  B.  Debt Securities Companies  C.  Merger Agreements and Short Form Mergers  D.  Applicability to Bank Loans  E.  Applicability to Lenders in Public Offerings of Debt Securities  1/  Issued  or  Guaranteed  by  Operating  "Margin stock" includes any equity security traded national securities exchange. 12 C.F.R. § 207.2(i).   https://fraser.stlouisfed.org r Federal Reserve Bank of St. Louis  on  a  %  a ,  -5-  IV.  V.  VI.  I.  ANALYSIS OF COMMENTS A.  Policy Considerations  B.  Factual Basis for Interpretative Rule  C.  Consistency with Margin Rules  D.  Prior Staff Opinions  E.  Role of the Board in Reviewing Specific Cases  PROCEDURAL ISSUES A.  The Administrative Procedure Act  B.  Need for Additional Public Comment  APPLICABILITY TO EXISTING FINANCING ARRANGEMENTS  BACKGROUND final interpretative rule  The in  May 1985, from  petitions for  meetings  Board's  consideration  of  two specific  interpretation of the application of  requirements. and  the  has evolved, beginning  This  process  with  has  affected  materials submitted  involved  parties,  the  margin  staff consultations  voluminous  briefing  by these parties, extensive staff analysis,  public comment and several meetings of the Board. In petition  to  May  1985,  the  the  Board  requesting  Unocal  Corporation a  submitted  determination  that  margin lending restrictions in Regulation G be applied securities issued Petroleum   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Company  by to  a  shell corporation  finance  a  tender  controlled  offer  for  a the  to debt  by  Mesa  Unocal's  ‘  -6 --  stock.  The  shell  corporation  other  than  offer  were successful, Mesa  the margin stock  to  held be  substantially acquired.  planned  If  to merge  no  assets  the  tender  the shell  with  Unocal, but even if successful, the tender offer would not haw' given Mesa the requisite number of shares of stock a merger with Unocal immediately. securities  would  constitute  indirectly secured  by  the  Unocal argued that these  purpose  margin  to complete  credit  stock  of  that  would  Unocal and  subject to the lending restrictions of Regulation G.  be thus  Howeve,-  Mesa's acquisition attempt was terminated and no Board  action  was taken at that time on the issues raised by the petition. In September 1985, a similar petition was filed the Board  by Revlon, Inc., seeking  a  determination  that  with the  lending restrictions in Regulation G applied to debt securities and other financing arrangements issued as  part  of  Pride/Revlon  its  attempt  transaction  to  acquire  / Revlon.2-  was structured  Mesa/Unocal acquisition attempt.  by Pantry Pride, Inc. The  Pantry  differently from  the  Pantry Pride, an operating  2/ The GAF Corporation has recently announced a tender offer for the shares of Union Carbide Corp. GAF would control a shell acquisition vehicle, but all debt securities to be issued to finance the tender offer would be issued or guaranteed by the parent corporation itself, an operating company with substantial non -margin stock assets. Together with its shell corporation, GAF, with assets of approximately $800 million and shareholders' equity of approximately $280 million, seeks to raise over $2.3 billion through issuance of debt securities.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -7--  company with substantial non-margin stock  assets, would  issue  nominally unsecured debt securities to fund a tender offer fo Revlon's stock, which  was margin stock.  In addition, Pantry  Pride controlled a shell corporation that would  be used as all  acquisition vehicle and would obtain a bank loan with  the  margin  loan  restrictions  applicable  banks (Regulation U, 12 C.F.R. Part 221).  to  that complied loans  Revlon's  from  petition  asserted that Pantry Pride proposed to obtain over $840 mil]ic, in  credit  existing  that  assets  could  not  be  supported  (approximately  (about $145 million).  by  Pantry  $400 million)  and  Pride's net  worth  The Board was made aware of the facts of  the Pantry Pride/Revlon transaction but no action was taken on Revlon's petition.2/ The Board has also received requests from a number of members of Congress  that  the  Board  specifically address  the  applicability of the margin lending restrictions to acquisition financing  arrangements,  especially  nominally  unsecured  debt  securities used in corporate takeover attempts. At meetings in September and  November 1985, the Board  considered the issues raised by the Unocal and Revlon petitions  3/ After the Revlon petition was filed, the terms of the Pantry Pride offer were altered several times. Recently, Pantry Pride completed its acquisition of Revlon after Revlon's attempt to accomplish a "friendly" leveraged buyout was invalidated by a Delaware court. The petition to the Board was withdrawn.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -8--  and the congressional requests.  On December 6, 1985, the Bc_r_.0  issued a proposed interpretation of Regulation G. The  proposed  interpretation  gives  the  Board's  view  with regard to whether the debt securities involved in the kin , of acquisitions at issue are  indirectly secured  interpretative rule  in  the  Unocal and  by margin stock.  Revlon situations  The  that provides guidance  proposal  to  the  is an  financial  community and to enforcement authorities as to a specific of transaction fall  within  indirectly  that the Board  the  scope  secured  by  of  believes, in  lending  margin  its  judgment, t(  transactions  stock.  that  such,  As  are  this  interpretation is not intended  as an exercise of the Board'  rulemaking authority conferred  by statute or  reviewing  courts,  but  as  descriptive  of  as binding  those  facts  upon  that  indicate a secured transaction within the meaning of the margin requirement rules. Board's  action  procedures  Moreover, as an  is  not  required  in  subject the  to  interpretative the  informal  Administrative  rule, the  rulemaking  Procedures  Act.  Nevertheless, the Board provided for a short period for comment by the  public in order  to assure  that  unanticipated  effects  from the proposed ruling do not arise. The Board The  comments  reasons stated  have  has received 87 comments on been  carefully  below, the  Board  considered  the proposal.  and,  has determined  for  the  to adopt  the  proposal with certain clarifications and limited modifications.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -9--  II.  BASIS OF THE INTERPRETATIVE RULE A.  The Interpretative Rule  The interpretation provides that the Board  is of the  view that, absent other defined circumstances describ ed debt securities issued acquisition  of  the  indirectly secured restrictions on shell  would  by a shell corporation  margin by  the  lending  have  stock margin  in  the  virtually  no  of  a  margin  for  company  than  the  are  purposes of  regulations.  business  significant business function other  to finance  target  stock  below,  the  Such  operations,  a  no  to acquire and  hold  the shares of the target company, and substantially no assets or cash flow to support the credit other than the margin stock that  it  has  acquired  or  intends  to  4/ acquire.-  The  presumption that the debt securities are indirectly secured  by  margin stock would not apply if there is specific evidence that lenders could  in good faith rely on  assets other  than  margin  stock as collateral, such as a guaranty of the debt securities by the shell corporation's parent company or  another  that  or  has  substantial non-margin  stock  assets  cash  company flow.  This presumption would also not apply if there is a merger  4/ Other forms business of organizations such as partnerships and business trusts with these characteristics would also be deemed to be shell corporations for the purpose of the interpretative rule.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -10-  agreement between  the acquiring  and  target companies entered  into at the time the commitment is made to purchase  the debt  securities or in any event before loan funds are advanced.  In  addition, the presumption would not apply if the obligation of the purchasers of the debt securities to advance funds to the shell corporation  is contingent on  the shell's acquisition of  the minimum number of shares necessary under law  to  effect  companies  a  merger  between  the  acquiring  without the approval of either  directors of the target company.  applicable state and  target  the shareholders or  In these circumstances it is  reasonable to assume that the lenders are looking to the target company's assets for repayment. The  interpretation  applies only  to shell companies.  Thus the interpretation provides that debt securities issued by an operating company with substantial assets or cash finance  the acquisition of margin stock  of a  flow  to  target company  would not be presumed to be indirectly secured by margin stock. B.  Rationale for the Interpretative Rule  The purpose of this interpretative rule is to provide guidance  in  determining  whether  nominally  unsecured  debt  securities issued to finance a tender offer for margin stock of a  target company are subject to the  existing  margin  lending  restrictions in Regulation G in the situations presented in the Unocal   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  and  Revlon  transactions.  Regulation G  describes  two  -11-  kinds of arrangements that are "include[dJ" within the meaning the disposition  of "indirect security" -- restrictions on  of  margin stock and acceleration of the maturity of the credit if provides that these  margin stock is disposed of -- but further do  arrangements  indirect security  not constitute  if,  among  other things, the lender in good faith has not relied upon the  credit.  encompasses a than  has  Board  the  indirect security as  other  in  extending  or  Id. § 207.2(f)(1), (f)(2)(i)-(iv).  1961  least  as collateral  stock  margin  wide  used  recognized in  the  However, since at the  that  Board's  the  maintaining  meaning  margin  of  regulations  variety of arrangements as to collateral,  a conventional direct security interest, that are  not described in the Regulation, but that serve to some extent to  protect  the  interest  of  the  lender.  12  C.F.R.  § 221.113(f). / It is clear that the debt securities issued by a shell corporation Regulation.  constitute  "purpose  credit"  as  defined  in  the  In addition, the purchasers of the debt securities  may qualify as "lenders" for purposes of the Regulation because they  purchase  the  debt  securities  in  very  large  amounts.  Although the debt securities issued by such a shell corporation  5/  in provisions the construed interpretation This indirect describing Regulation U (governing credit by banks) security, which are the same as those in Regulation G.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -12-  are by their terms not directly secured  by margin stock, the  Board  below,  believes, for  limited  situation  the  reasons  described  stated  these  that  debt securities  in  the  would  "indirectly secured" by the margin stock to be acquired  be  withil,  the meaning of the provisions of Regulation G. C.  Lenders' Reliance on Margin Stock.  As the interpretative rule set out at the end of the Notice points out, the narrow  situation  purchasers  of  Board  described  the  debt  is of the opinion in  the  securities  that  in  interpretation, issued  by  the  the  the  shell  corporation to finance the acquisition of margin stock of the target can be viewed reasonably as relying on the margin stock as collateral for  the credit, regardless of  the  lack  of  a  conventional direct security agreement. As the interpretative rule points out, under interpretation  of  the  margin  regulations,  loans  to  a  prior an  investment company, the assets of which consist almost entirel y of stock, are regarded  as indirectly secured  since the lenders could not in good faith lend without  reliance  on  Service T 5-917.12.  the  stock.  The Board  Federal  by  that stock,  to the company  Reserve  Regulatory  believes that the rationale of  this prior ruling applies to the debt securities issued type of shell acquisition vehicle involved transaction.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  in  by the  the Mesa/Unocal  -13-  As shell  described  would  have  in  the  virtually  interpretative no  business  significant business function other  ruling, such  operations,  than  a  no  to acquire and  hold  the shares of the target company, and substantially no assets or cash flow to support the credit other than the margin stock that it has acquired or intends to acquire.  In this situation,  the Board believes that the only significant asset available to support  the  credit  is  the  margin  stock  lender must be relying on that stock  and, therefore,  as collateral  the  to secure  repayment. The fact that, as a number of comments point out, the shell corporation  intends  to  vote  its shares of  the  target  company to merge with the target does not, in the Board's view, change the result.  In the Mesa/Unocal transaction, which forms  the basis for the interpretation, the  tender offer  would  not  have sought to acquire a sufficient number of shares of stock of the target company to permit a "short-form" merger the target and  the shell corporation.  Nor  agreement between Mesa and Unocal at the committed. this  the loans were  If the target company were to oppose the merger  situation,  shell  was there a merger  time  the  shell  corporation  may  significant  be  period  forced of  to  time.  hold  the  During  be  may  consummate the acquisition immediately or the  between  to  possibly at all and  margin this  unable  in  stock  time,  the  for  a  Board  believes that the lenders could only rely on the margin stock,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -14-  not  assets of  the  the  target, as security for  the  Disclosures pursuant to the securities laws made  credit.  by acquiring  firms in these situations support this view by stating that the proposed  merger may not take place for  an extended  period of  /  time or at  purposes  For  of  the  margin  regulations  the  Board  regards the time a commitment to extend credit is entered as  the  margin  point at lending  Regulatory  which  a  determination  restrictions  Service  V 5-306.  apply.  is See  made  whether  Federal  Accordingly,  in  the  into  the  Reserve Board's  opinion, at that time the lender can be viewed as relying on the margin stock as collateral for the credit.  This position  is  the  supported  by  the  fact  that  the  lenders  to  shell  corporation described above will, at the time of commitment of their loan, be which  unable to  the shell would  predict  hold  the  length  of  time  during  no significant assets other  than  margin stock. D.  Practical Restriction on Disposition.  The Board's presumption  that in  the shell corporation  situation the lenders are relying for repayment on the margin  6/ See, e.g., Schedule 14D-1 filed by Mesa Partners II and Mesa Eastern, Inc. to acquire stock of Unocal Corp., at 21 (April 8, 1985); Offer by Coach Acquisition Inc. to Purchase Securities of MidCon Corp., at 28 (Dec. 16, 1985).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -15-  stock  is  further  disposition  of  supported  the  margin  by  practical  stock  by  the  limitations  shell  on  corporation.  Regulation G includes within the scope of "indirectly secured" any  arrangement  in  borrowers' legal margin  stock  credit.  which  there  right or  owned  by  is  a  practical  the  borrower  restriction  ability during  12 C.F.R. § 207.2(f)(1)(i).  margin  stock  of  a  the  dispose  the life  of  of the  Where credit is extended  to a shell corporation whose basic purpose hold  to  on  particular  is  company,  to acquire and as  in  the  Mesa/Unocal transaction, the Board is of the view that there is a practical restriction on the ability of the shell corporation to dispose of that margin stock. would  The Board  be reasonable to assume that lenders  believes that it would  not extend  credit to such a shell acquisition vehicle unless there were an understanding company.  that  This  it  will  hold  the  understanding, as  a  stock  of  practical  a  particular  matter,  would  discourage the shell corporation from disposing of the target's stock in order to replace it with other assets. However, restriction  on  under  the  Regulation G,  disposition  of  even  margin  if  there  stock  or  is  a  other  evidence of indirect security, credit is not indirectly secured by margin stock  if the lender in  good  faith did  margin stock as collateral in extending credit. the  presumption  contained  course, not apply   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  where  in  there  the  interpretation  not rely on Accordingly, would,  is specific evidence  that  of the  •  purchasers of the debt securities in good faith have not re on the margin stock to be acquired by the shell corporation aL, collateral.  There are certain specific situations  where  the  Board believes this would be true as a general matter and theLc, situations where the presumption would not apply are set out detail in Section III. B. below. III.  COVERAGE OF INTERPRETATIVE RULE A.  Limited Scope of Coverage  The interpretative rule guidance as to whether stock"  as  used  in  is intended  only  to  the term "indirectly secured  Regulation G  would  apply  to  provide  by margin  the  shell  corporation financing arrangements of the type presented in the Mesa/Unocal  transaction.  Credit  different facts are not covered will continue to be covered  transactions  involvin9  by this interpretation; the/  by existing law, regulations and  interpretations. Nevertheless, certain comments raised questions about whether  various  classes  within the scope of the note  that four  general  of  acquisitions  interpretation. types of  would  be  The Board  acquisition  included wishes  to  transactions  those involving (a) operating companies with substantial assets or cash  flow, (b) guarantees of  borrowing  by companies  substantial assets or cash flow, (c) agreed -upon  mergers, and  (d) statutory "short-form" mergers -- are not covered presumption made with respect to shell companies.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  with  by  the  These four  -17-  exclusions are based on supporting that  the  stock --  the  would  not  arrangements, even  Board  relying cover  for  repayment  these  types  on  of  that,  even  as an  where  shell  margin  acquisition  acquisition  a  to believe  the  if debt securities are issued  that is employed  believes  that the rationaJe  interpretation -- reasonable cause  lenders are  corporation  the Board's view  by a shel  vehicle.  corporation  involved, lenders would not be relying on margin stock  i. where  the loan is guaranteed by an operating company with substanti,i' assets or  cash  flow or  where  the  borrower  company with the same characteristics.  is  an  operating  Similarly, the lender  would not be relying on the margin stock if there is a merger agreement between  the acquiring and  target companies entered  into at the time the commitment is made to purchase the deh' securities or in any event before the loan funds are advancec, The same is true where the obligation of the purchasers of debt securities to advance funds to the shell corporation  is  contingent on the shell's acquisition of the minimum number shares necessary under applicable state law to effect a merget between the acquiring and target companies without the approval of either the shareholders or directors of the target company. These exclusions from the application of the presumption are described in detail in the following two sections.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -18-  B.  Debt Securities Issued or Guaranteed by Operating Companies.  The interpretative rule makes clear that,  as  in  the  Pantry  Pride/Revlon  the Board's view  transaction,  nominally unsecured debt securities are issue d  where  by an operating  company with substantial non-margin stock asset s or  cash  flow  to finance acquisition of margin stock, the debt securities are not presumed Since  the  to be indirectly secured  debt  securities  are  by the margin stock.  issued  by  a  company  with  a  history of ongoing business operations, the Board believes tha a presumption that the lenders are relying on the margin stock as  a  source  reasonable.  of For  repayment  for  the  credit  would  not  be  the same reasons, the Board reaches the same  conclusion in the situation where there is borro wing by a shell corporation which is guaranteed by an opera ting parent or other company with substantial non-margin assets or cash flow. Since the Board  is dealing only with  the question of  whether a presumption of reliance on the margi n stock should L made, there  is  no reason  to  include  additional comment, as  provided in the last sentence of paragraph (h) of the propos(: -interpretation, on the scope of the applicatio n of Regulation when the presumption is not applicable. sentence  of  paragraph (h)  is  not  Accordingly, the last  necessary  to  interpretation and that sentence has been deleted.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  the  -19-  A number of comments questioned, however, whether debt securities  issued  by  operating  companies  to  finance  tender  offers for margin stock might be covered by the interpretation, if the amount of securities to be issued significantly exceeds the assets of the operating company.  Conversely, commentators  also raised questions about the kinds of acquisition  vehicles  that would be considered a shell corporation within the meaning of the interpretation, as well as how much assets or cash flow would  be necessary for  the acquiring company to fall outside  the rebuttable presumption. As explained securities assets or stock  issued  by  cash flow  purchased  above, the Board does not presume debr an  to  with  operating be  the  company  with  indirectly secured proceeds  of  the  substantial  by  debt  the  margin  securities.  Guidance as to the Board's views has already been noted insofar as  it considers  both  the  acquisition  proposals  made  by  the  operating companies involved in the offers made by Pantry Pride and  by  GAF. '  arrangements  as  The  Board  falling  does  within  the  not  consider  presumption  these of  indirect  security contained in the interpretative rule adopted today. Moreover, with shell  corporation  respect  that  falls  to  the  within  characteristics the  scope  of  presumption, the Board has already noted that such a  7/  See Section I. above.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  of  the  a  -20--  corporation  would  have  (1) virtually  significant business function other  no  than  operations;  to acquire and  the margin stock of the target company; and  the  margin  acquire.  stock  that  it  has  hold  (3) substantially  no assets or cash flow to support credit extended than  (2) no  acquired  or  to it other  intends  The Board also notes that the controlling  to  principle  of the interpretation is that credit to a shell corporation presumed  to  be  indirectly  relatively  limited  assets  cash  or  secured  circumstance  flow  of  the  by  margin  where  shell  the  stock  in  non-margin  corporation  is  is  the stock  so  insubstantial that a lender could not in good faith rely on it in extending credit to the shell corporation. view  In  of  interpretation, the  the  of  the  shell  scope  of  the  Board does not anticipate  additional interpretation scope  narrow  will be necessary  corporation  concept  proposed that extensive  to delineate  contained  in  interpretative rule or the margin rules as a whole. Board and  the staff, as in the past, are prepared  views on the compatibility of proposed rules, the Board reduce  the  need  expects that the for  the  While the to provide  transactions with  interpretative  the  these  rule should  individual interpretations such  as  those  requested in the Mesa/Unocal, Revlon/Pantry Pride and GAF/Unio n Carbide  situations.  Questions concerning  application  of  the  interpretation to individual fact situations cannot, of course,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -21-  be excluded, and can be expected litigation on  other  to arise in conjunction  matters between  companies  with  involved.  The  Board has had a longstanding policy that, where the parties are involved  in  litigation, the Board  that might affect this litigation. fully consistent with  would  refrain from comment  Moreover, this policy is  the longstanding position of the Board  that a private right of action under the margin requirements is an  important  mechanism  for  effective  resolution  of  margin  requirements issues in particular factual situations. Paragraphs (b) and (h) of the proposed have  been  limited  redrafted  to  the  to emphasize that the  types  of  fact situations  interpretation  Board's involved  views are with  the  Unocal and Revlon transactions. C.  Merger Agreements and Short Form Mergers  The rationale of the presumption the case of the financing of a merger shell corporation is employed time  the financing  would  not apply in  transaction, even  if a  to effect the merger if, at the  is committed or, in any event before  the  loan funds are advanced, a merger agreement has been executed or  the merger  may be  accomplished  by operation  of law.  As  explained above, the Board's presumption of indirect security is premised on its judgment that in the narrow fact situation presented  there  corporation  would  is  uncertainty  as  to  whether  be merged promptly with  shell  the target company.  However, this rationale would not apply if there   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  the  is a  merger  -22-  agreement between  the acquiring and  target companies entered  into at the time the commitment is made to purchase securities. immediately  In  this  succeed  case  to  the  the  surviving  assets  and  the dPbt  corporation  liabilities  can  of  the  subsidiary and the target company and the surviving corporation becomes Thus,  a  in  wholly this  owned  subsidiary  situation,  reasonable to assume  that  the  of  Board  the  holding  believes  that  the  target  company,  it  is  purchasers of any debt securities  issued by the shell corporation would be relying on of  company.  not  its  stock,  as  the  the assets  source  of  repayment for the credit. Similarly, the Board also regards the rationale of the interpretation  as  not  applying  if  the  obligation  of  the  purchasers of the debt securities to advance funds to the she]] corporation  is contingent on  the  shell's  acquisition  of  the  minimum number of shares necessary under applicable state la to effect a merger  between the acquiring and  target companies  without approval of the shareholders or directors of the target company (e.g., Delaware General Corporation Law, section and New York Business Corporation Law, section 905).  253,  The Board  believes that, as some commentators have pointed out, a lender extending  credit  to  circumstances could  finance rely on  a  tender  the  assets  offer and  in  these  earnings of  the  target corporation, not its stock, as the source of collateral and repayment of the credit.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The interpretative rule has been  -23-  amended  to reflect the judgments contained  in  this paragripD  and the preceding paragraph. D.  Applicability to Bank Loans  Commentators have asked  whether  bank loans (governed  by Regulation U) to the kind of shell corporation described the interpretation would similarly be "indirectly secured" margin stock.  Regulation U applies margin lending restrictiol,  to purpose loans made by banks that are directly or  indirectl  secured by margin stock and defines "indirectly secured" in the same manner as Regulation G. with other  12 C.F.R. §§ 221.3(a); .2(g).  A!  interpretations of "indirectly secured," the Board  would regard this interpretation as applying interchangeably 1 credit  covered  by  either  Regulation.  /  However,  in  case  coming to its attention, the Board notes that bank loans to be structured so as to provide security, including negati\ pledge clauses, that fall specifically  within  Regulation U, in contrast to credit extended lenders that purchase debt securities.  the by  scope  Regulation  This interpretation  not likely to have a significant impact on bank loans governed by Regulation U.  8/ Regulation T, governing credit by brokers and dealers, prohibits a broker/dealer from extending purpose credit on al , unsecured basis or on any collateral other than securities, However, a broker/dealer acting as an investment banker ma, arrange such credit if it does not violate Regulations G or IT 12 C.F.R. § 220.13.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -24-  E.  Applicability to Lenders in Public Offerings ()Debt Securities  The proposed of  this  interpretation stated  interpretation,  privately  placed  and  there  publicly  is  no  that for  distinction  distributed  debt  purposes  between  securities.  Thus, under the proposed interpretation, a person Who purcha. a sufficient amount of debt securities of the kind described in the  interpretation  would  be  regarded  to qualify as a lender as  subject  to  the  restrictions, regardless of whether  the  under  margin  Regulatioh lending  debt securities  de  purchased in a public offering or in a private placement. Several commentators that are  issued  in  public  state  that  offerings  if debt securitie  are  viewed  as  purpose  credit that is subject to the margin lending restrictions, serious  operational  compliance  with  problems  those  rules.  would For  result example,  in  assuring  purchasers  ot  publicly issued debt securities in the secondary market may not have  access  to  the  disclosure  statements  required  by  the  securities laws and thus may not be aware that the procee ds of the debt securities were used to purchase margin stock and that the securities would be subject to the margin rules.  Questions  have also been raised about the consistency of the propos al this area with past Board practice. This  provision  in  the  proposed  interpretation  was  intended at least in part to address the kind of nominal public   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -25--  offering of debt securities involved in the Pantry Pride/Rex.;: transaction,  in  securities with  which  acquiring  the SEC as  a  firms  registered  the  debt  public offering, but sold  the  securities in minimum amounts of $2.5 million, so that the sale in actual practice resembled a private placement.  Although the  staff has stated that publicly offered debt securities are no subject to the margin regulations, the staff opinions assumed bona fide  public offerings for  the  purposes of applying  the  9/ margin requirements.Board  The  believes  that in  this  case  questions  of  whether purchasers of publicly issued debt securities should be treated as lenders for purposes of the margin rules are best dealt  with  in  the  context  of  a  formal  provisions of Regulation G, since such involve  an  provisions  interpretation of  of  Regulation G.  words  and, with  the  caveat  an  used  Accordingly,  adopting paragraph (i) of the proposed time  amendment  noted  action in the  the  to  the  would  not  existing  Board  is  no.  interpretation at this  above, staff opinions  may  continue to be relied on.  9/ A court reviewing Panty Pride's securities laws disclosures with respect to compliance with the margin regulations stated that, while obliged to defer to the existing interpretation of the Board's staff, the argument that the debt securities issued by Panty Pride were not exempt from the margin rules had much to commend it. Revlon, Inc. v. Pantry Pride, Inc. No. 85-497 JJF (D. Del. Sept. 12, 1985), slip op. at 22-24.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -26-  IV.  ANALYSIS OF COMMENTS Board  The More  than  half  proposal.  received  of  the  These  interpretation  total of 87  a  comments  were  commentators  for  a  number  comments.  supportive  favored  of  public  the  reasons,  of  the  proposed  including  (1) its  probable effect of protecting small investors by discouraging risky investment by pension funds and other help in restoring integrity in  trustees, (2) its  the nation's financial markets,  and (3) its effect as a curb on speculation and use  of  debt  for  speculative  comments, including other  government  justification  of  the  departments,  and  interpretative  those  purposes.  rule  underlying as  well as  The  the excessive unfavorable  Department of  reflected  rationale with  Justice  concerns  for  respect  the to  and  with  proposed whether  the  Board had followed the proper procedure in issuing the proposed interpretation. More specifically, the comments, both  pro  and  con,  addressed issues in the following areas:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  (1)  policy implications The interpretation;  (2)  Whether the proposed interpretation has any basis in fact; whether it is consistent with the purposes of margin regulation; whether it is consistent with prior Board and staff rulings; and whether it would put the Board in an unprecedented regulatory role;  (3)  Whether the Board had complied with the Administrative Procedure Act in proposing the interpretation;  of  the  proposed  I,  -27-  (4)  Whether certain situations and transactions would be covered by the proposed interpretatiol. and  (5)  What transactions would grandfather provisions interpretation.  be of  covered by the the proposed  Some of the comments have already been addressed the preceding material discussing interpretative  rule.  The  the  following  basis and sections  scope of  address  in the  other  issues raised by the comments. Policy Considerations  A.  Many commentators addressed  policy issues relating  to  the advisability of regulating corporate acquisitions and debt generally.  Some  interpretation  commentators  on  the  grounds  supported that  the  the  recent  debt-financed corporate acquisitions should  commentators  also  argue  that  such  growth  be curbed  excessive debt for speculation in stocks should These  Board's of  and  the  be restrained.  financing  diverts  capital flows away from productive purposes and reduces credit available debt  that  to such impairs  corporations  and  borrowers, results the  increases  bankruptcies, results repay  debt  rather  financial  in  than  excessive  condition  the  corporate being  in  used  potential funds for  of  the  for  being  corporate issuing major  diverted  productive  to  growth,  requires emphasis by management on short-term results to the detriment of sound corporate growth, results in higher cost of capital, which in   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  turn  is passed on to consumers, and  results  •  -28-  in distortions that impair the integrity and stability of the national securities markets. On  the other hand, many comments, including  those of  the Department of Justice, for itself and on behalf of a number of  government  opposed  the  agencies,  the  interpretation,  regulation  of  interest.  These  have  and  corporate  productive  Federal  contending  acquisitions  comments  state  economic  effects,  Trade that  is  not  Commission, governmental  in  the  that corporate such  as  public  acquisitions  removal  of  inefficient management, and increases in the value of corporate stock,  and  that  there  is  no  corporate debt is excessive or debt  securities  issued  to  evidence would  finance  that  the  level  of  be adversely affected corporate  by  acquisitions.  Among the other points raised in these comments are assertions that the interpretation frustrates the congressional objective of neutrality with regard  to corporate takeovers expressed  the Williams Act and  the Hart-Scott-Rodino Act, would  disparate  competition  shifting  effect the  on  balance  that  for  presently  corporate exists  to  have a  control favor  in  by  large  corporations over smaller ones, would discriminate in favor of foreign firms that may borrow abroad to finance the takeover of U.S. companies without being limited by the margin regulations, would  increase  acquisition  costs, and  will  have  an  effect on economic efficiency and financial markets.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  adverse  -29-  A number of comments argue that the interpretation  is  not necessary to accomplish the basic objectives of the Board's authority to set margin requirements.  Drexel Burnham Lambert,  Inc. and other commentators state that there is no regulatory need to protect the purchasers of the debt securities involv ed, who are financially sophisticated, and debt securities produces  neither  excessive  diverts credit from  price  commentators, however,  fluctuations  believe  carry out the purposes for was  enacted.  members  of  For  the  of  that  which  example,  House  that the issuance of the  a  in  the  the  uses  market.  nor  Other  interpretation  will  the margin -setting authority  comment  submitted  Representatives  interpretation addresses many of  other  the same  states  by  twelve  that  concerns  the  that led  Congress to enact the margin authority -- "speculation leadin g to unstable markets and an undermined public confidence in  the  soundness of publicly traded" securities. The staff  study,  comments  also discuss  transmitted  evaluating federal margin  to  a  Federal  Congress  in  Reserve  January  Board  1985,  regulation,'which concluded  that  there are serious doubts about the need for continuing federa l regulation  to  foster  the  objectives  Congress in enacting the legislation.  originally  sought  Drexel Burnham and other  commentators assert that the extension of the margin  10/  A Review and Evaluation of Federal Margin Regulation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  by  -30-  regulations embodied in the interpretation is inconsistent la.0 the Board's recognition of the general inefficiency of margin regulation.  On  the other  hand, some members of Congress and  others point out that whatever  questions the Board  has about  the continuing need for margin requirement law and regula tions, the existing margin law and regulations must be enforc ed and unless the existing regulations are amended by the Board, they must apply equally to all transactions covered by their terms. The issues  Board  concerning  recognizes highly  the  conflicting  leveraged  mergers,  public and  policy  does  not  believe rulemaking or interpretations of margin regulations :Ire appropriate means for settling such  issues, which are properly  matters for Congressional consideration.  Moreover, the Board  does not believe the interpretation set forth here is likely to substantially alter, in itself, the level of merger activi ty or amount of debt created.  Rather, the interpretation is intended  to make clear the Board's view that a specific narrow class of acquisition  financing  transactions  falls  requirements of the margin regulations The Board the  study  as currently  This conclusion which  focuses  consideration for  is in on  Securities Exchange  no way  undermined  recommendations  future action and  for  not on  written.  Act of  by the staff legislative  administration of  existing law so long as that law is in place.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  the  believes that the interpretation is consistent with  purposes of Section 7 of the  1934.  within  -31-  In conjunction with Regulations T and U, Regulation C was adopted by the Board to carry out the purposes of Section of the Securities Exchange Act of 1934, inter alia, to prevent excessive  use  of credit for  stock  market  speculation.  The  interpretative rule simply applies Regulation G to one kind ot fact situation  in  a  manner  in  which  the Board  believes  is  consistent with the purposes Congress had in mind in adopting the  margin  requirement legislation  Regulation G. Congress  as  regulations.  In doing embodied  so,  in  and  which  is  it carries out the  Section 7  and  in  covered  by  intention of  the  While the Board carefully considered  margin the policy  arguments made by the commentators and others that the margin requirements should not be applied to the facts covered by the interpretative rule, on balance the Board decided that fair and uniform administration of existing law requires that the margin regulations be applied in situations where it is reasonable to conclude  that  purpose  credit  is  being  indirectly secured by margin stock. changes in the  extended  that  is  Proposals for fundamental  margin requirements are properly addressed  Congress, not to the Board, which Congress has enacted it.  to  must interpret the law as  As noted in a number of comments and  by the Board itself in setting out the proposed interpretation, the Board would welcome such Congressional review. With  respect  to  the  contentions  that  the  interpretation would result in disparate treatment of various   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -32-  classes  of  transactions  foreign  and  domestic lenders, large  target companies, and Board  and  parties,  hostile and  and  example,  existing  preclude  adoption  regulatory  transaction.  of  and  friendly acquisitions, the  an  requirements  betwc,.-27.:  small acquiring  believes that considerations of this kind  cannot,  do  interpretation to  a  not,  applying  particular' financing  On the contrary, fair application of the margi  rules requires that they be applied comes  for  within  the  scope  of  those  to a fact situation  rules.  Although  regulations by their very nature impose a greater  tL.  margin  burden  where  there is a greater need to borrow or a lack of other assets to support the borrowing, this burden is the inevitable produc t of the enactment of margin authority by Congress designed to limit borrowing  for  definitions subjects  contained  all  11/ purposes.  speculative  acquiring  in  these  and  rules,  target  In the  applying  the  interpretation  companies  to  the  same  standards provided for under existing law and rules. Other  commentators  have suggested  that the  proposi  contravenes governmental policy of neutrality toward takeovers  11/ Proposals to amend the securities laws to apply Section 7 to foreign bidders have been considered by Congre. but have thus far not been adopted. On October 13, 1981, the House of Representatives approved a bill (H.R. 4145) that would have made foreign borrowers obtaining credit to purcha se U.S. securities from non-U.S. lenders subject to same margin requirements applicable to U.S. persons. 127 Cong. Rec. 23762. A similar bill (S. 289) was not acted upon by the Senate.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -33-  and other acquisitions embodied in the Williams Act amendments to the Securities Exchange Act (15 U.S.C. 78m Hart-Scott-Rodino U.S.C. 18a).  Anti-trust  Even  Improvements  before the  (d-e)) and  Act  Williams and  of  1976  the  (15  Hart-Scott-Rodino  Acts, it had been a longstanding position of the Board that the margin regulations apply to a loan  to purchase a - controlling  interest in a corporation (12 C.F.R. § 221.110, 45 Fed. Res. Bull. 256 (1959); Federal Reserve and  Regulatory Service 5 5-81!  there is no evidence that those Acts in any way exemptr—  takeover  attempts  from  the  margin  requirements.  The  interpretation is predicated on a Board policy of administerincj the margin regulations fairly and equally with respect to all market there  participants.  Moreover,  is any conflict between  the  the  Board  narrow  does  not  believr'  interpretative  and the other statutes cited by the commentators. B.  Factual Basis for Interpretative Rule  A number the  of comments addressed  interpretation,  i.e.,  that  the  the factual basis  purchasers  securities issued by the shell corporations look  of  the  debt  to the margih  stock, not the assets of the target as the source for repayment of the credit. offering  any  For example, some commentators stated, without  specific  evidence,  that  lenders to the shell corporation look  in  their  experience  to the assets and cash  flow of the target company as the source of repayment, since   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -34-  the shell corporation holds  margin stock only  as  an  interim  step in the planned acquisition of the target company. comments  further  state  that,  in  many  cases,  These  financing  arrangements are contingent on acquisition of legal contro l of the target and that the shell corporation is not analogous to an investment company, because, unlike the shell," an invest ment company does not exercise long-term control over the compan ies in which it invests. On the other hand, a number of comments supported the interpretation. Manufacturers and  For  example,  twelve  the  members  National  of  the  Association  U.S. Senate  of  stated  that, in the circumstances described in the interpretati on, the shell corporation would hold no assets other than margin stock to which the lenders would have recourse.  Dillon, Read & Co.,  an investment banker, stated that debt securities issued by a shell  corporation  "from  a  practical  standpoint . . .  are  indirectly secured by stock of the target corporation. " The Board believes that the comments of Drexel Burnham and other investment bankers on acquisitions generally do not undermine  the reasonableness of  the  conclusion  that  in  the  limited circumstances described in the interpretati on the debt securities should be regarded as indirectly secured by margin stock.  The general comments do  not consider  the  particular  circumstances raised by the Mesa/Unocal transaction target   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  company's  efforts  to  oppose  the  acquisition  that the could  -35-  significantly delay or prevent consummation of the  merger and  the specific admissions in securities disclosure materials that this could, in fact, be the case. As explained above, this circumstance would not cover, and  the interpretation  where  it  is  clear  is  that  not  when  intended  the  to cover,  situations  shell corporation  acquires  margin stock it will be able to effect an immediate merger with the target.  In addition, in  the situation  identified  in the  interpretation, the Board believes that the shell corporation should be viewed as the equivalent of an investment company, since  until  the  accomplished, would  not  merger  the  Board  exercise  with  the  believes  effective  target  that  control  the  is  actually  shell  over  corporation  the  target  12./ company. C.  Consistency with Margin Rules  Several  comments  assert  that  the  interpretation  inconsistent with the provisions in  Regulation G  indirect  state  security.  These  comments  that  relating under  is to  the  Regulation, in order for credit to be indirectly secured by  12/  One commentator argues that the high rate of interest paid on the debt securities issued by the shell corporation is necessary to compensate the lenders for extending credit that is truly unsecured. However, no evidence has been produced that the lenders are in fact relying on this characteristic of the debt instrument to the exclusion of the margin stock. On the other hand, the fact that the shell corporation has no other assets or cash flow to permit repayment suggests at least partial reliance on the margin stock.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ,  -36-  margin stock, there must be a restriction on the dispositio n of margin stock, some provision for acceleration of the  maturity  of the credit if margin stock is disposed of, or at a minimu m some "arrangement" between  the  lender  none of these factors are present in  and  borrower  the case  of  and  that  the shell  corporation's debt securities described in the interpretation. The Board consistent with  is of the  the  plain  view  language  that this argument is not of  the  Regulation, which  provides that "[i]ndirectly secured" includes any arran gement with the lender under which the borrower's right or ability to dispose of margin stock is in any way restricted. § 207.2(f)(1)(i).  The  Board  is  of  the  view,  12 C.F.R.  as  explained  above, that in the shell corporation situation outlined interpretation, there is a restriction on  in  the  the ability of the  shell corporation to dispose of the margin stock of the target company within the scope of this definition. believes that the means  that  the  use of the  factors  The Board  term "includes" in  identified  in  the  also  Regulation G  Regulation  intended to be illustrative of the circumstances in  are  which debt  may be found to be indirectly secured by margin stock but not a comprehensive  recital  noted  longstanding  that  a  of  such  circumstances.  interpretation  of  It should the  be  analogous  provision in Regulation U states that indirect secur ity may be found  in  "a  § 221.113(f).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  variety The  of  Board  circumstances." notes  that,  as  12  C.F.R.  indicated  by  the  -37-  investment  company  interpretation  described  above,  purpose  credit has been found to be indirectly secured by stock based solely on the asset structure of the borrower, where neither of the  factors  identified  in  the  Regulation' were  present.  Federal Reserve Regulatory Service If 5-917.12. D.  Prior Staff Opinions  Several comments cite a series of prior opinions by the Board's staff and the staff of the Federal Reserve Bank of New York, each of which concluded, based on the facts involved, that credit extended to a shell corporation to finance a tender offer for margin stock of a particular target company was not indirectly Drexel  secured  Burnham  and  by  the  margin  Merrill  Lynch  stock &  to  Co.  be  14/ acquired. -  assert  that  the  interpretative rule is a departure from these existing staff opinions and that no explanation for this has been provided.  13/  The comments of the Department of Justice cite several staff interpretations relating to indirect security that turn on the existence of restrictions on the disposition of margin stock. While the staff's analysis of this question often focuses on restrictions on disposition, nothing in the cited interpretation (or in any other interpretation) states that this factor is determinative for purposes of applying the regulatory provision relating to credit indirectly secured by margin stock. 14/  Federal Reserve Regulatory Service VI 5-917.15; 5-357.1; 5-357.21; staff letters dated March 19, 1982, April 13, 1984, May 1, 1984, Jan. 11, 1985.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  However, consistently  made  restrictions  apply  interest  in  corporation the  since  at  least  clear  its  view  that  used  to  to credit  a corporation  by  1959,  the  the  margin  acquire  purchasing  Board  the  a  has  lending  controlling  stock  of  that  where the credit meets the criteria specified  Regulation.'  The  staff  has  also  made  clear  that  in  it  regards credit extended to an investment company, substantially all of whose assets are composed of margin stock, as indirectly secured by the stock,' and that an exception from "indirectly secured" does not apply when only asset of the  Board  a  finds  shell that  -17/ corporation. the  rationale  of  the term  margin stock As  explained  these  is the above,  opinions  is  directly applicable to the shell corporation situation which is the subject of this interpretative rule. The opinions of  comments the  staff  suggest, express  however, the  view  that  seven  prior  that purpose credit  extended to a shell corporation to finance the acquisition of margin stock was not indirectly secured by margin stock.  15/  Federal Reserve Regulatory Service V 5-815. This opinion applies to a bank loan made under Regulation U, but applies equally to Regulation G which uses the same "indirectly secured" language. 16/  Id., V 5-917.12.  17/  Id., V 5-917.17.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -39-  Those staff opinions did Board  has identified  not focus on  the factors which  th(,  in this interpretation as essential to a  determination of whether the debt issued by a shell corpora tion to  finance  presumed  the  acquisiton  of  a  company's  to be indirectly secured  stock  could  by this stock.-18/  be  This new  essential factor -- the potential for indefinite holding by shell  corporation  of  the  target's  raised only for the first time in Board.  Thus, where this factor  stock --  was  explicitly  the Unocal petition  is present, the  opinions are not relevant to a determination of  Lhe  to thi'  prior  stafL  whether  th(-  presumption contained in the Board's interpretation applies . E.  Role of the Board in Reviewing Specific Cases  Finally, some commentators assert that adoption of tL interpretation unauthorized takeovers  will place the Board  role of reviewing  generally  and  that  the  this  costs of regulatory compliance.  in  the  unprecedented  financing review  The Board  and  arrangements of  will  increase  the  notes that it has  long been placed in the position of making such interpretatinn' in response to requests from lenders and others.  It is for  18/ The Board also notes that the staff interpretations were limited to hypothetical facts presented and involved a variety of financing techniques and other factors, such as guarant ees of the shell corporation's debt, as well as proposals to acquire all of the stock of the target company that could have resulted in the same findings with respect to indirect securit y as would occur under the interpretative rule.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -40-  that very reason -- specific requests for clarification of thrs rules  applicable  to  shell  companies --  that  prepared to adopt this interpretative rule.  Board  the  is  The Board believes  that adoption of this rule should, in fact, reduce uncertainty and reduce the need for future interpretations. interpretation acquisition  is designed  financing  to deal  with  transactions --  a  Moreover, the  limited  those  in  class of  which  debt  securities are issued by a shell corporation and, accordingly, is  not  expected  transactions.  to apply  to  a  large  number  of  acquisition  Thus, administrative review of a large number of  transactions should not be necessary and the number of requests related to the narrow financing arrangements described by th( interpretation should be limited in number.  Finally, the Board  has noted in Section III. B. of this Notice the important rd that the courts play in applying margin rules to  the factual  issues arising in specific cases. V.  PROCEDURAL ISSUES A.  The Administrative Procedure Act  Several comments expressed the view the proposed  interpretation  would  violate  that adoption  the Administrative  Procedure Act ("APA") because the Board has not followed all if the procedures for rulemaking set forth in that Act.  However,  the action taken by the Board here is interpretative  and  adopted in accordance with the provisions of the APA.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  is  -41-  The APA provides that in promulgating "legislativ, "substantive" rules, an agency must provide notice of proposed rulemaking, opportunity for public comment, a statement of the basis and purpose of the rule, and 5 U.S.C.  § 553(b)-(d).  provided  that  these  "interpretative legislative  or  Congress  has,  requirements  rules."  5  substantive  U.S.C. rule  a delayed  is  do  effective date,  however, not  apply  § 553(b)(A), issued  specifically to  (c)(2).  pursuant  to  A a  specific grant of authority to an agency to make rules havj 12/ the force of law.  A rule is interpretative if it  is no  issued pursuant to specific delegated rulemaking power  or  the agency intends the rule to be no more than an expression its construction of a statute or authorization notice  and  to  issue  comment  20 rule.--/  interpretative  reflects  its  The Congressional  rules  awareness  without  that  the  publi( public  interest in expediting the administrative process, in complex situations  involving  application  of  existing  law,  required  flexibility to permit agencies to interpret that law  12/ E.g., Batterton v. Francis, 432 U.S. 416, 425 at n.9 (1977); Chamber of Commerce of the United States v. OSHA, 636 F.2d 464, 468 (D.C. Cir. 1980). 20/  E.g., Chamber of Commerce of the United States v. OSHA, supra 636 F.2d at 468.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -42-  without adhering to the rulemaking procedures that had applied  when  their  actions  involved  creating  new  to be  legal  21/ obligations. While the outer boundaries of the distinction between legislative  and  interpretative  rules  clarified by the courts, numerous certain general principles for types of rules. delegated reviewing expertise;  not  been  decisions have  authority;  courts, although intended  (2) is  not  they will defer by  fully  established  distinguishing between the two  An interpretative rule (1) does  legislative  (3) is  have  the  not exercise  binding  on  to administrative  promulgating  agency  as  interpretative and non-binding; and (4) advises the public oi the agency's construction of the statutes and  rules which  it  administers by clarifying or explaining an existing statute rule.  An  agency's  statement  that  it  is  adopting  an  interpretative rule is given great weight in the judicial  21/  See Senate Comm. on the Judiciary, Administrative Procedure Act, Legislative History, S.Rep. No. 248, 79th Cong. 2d Sess. 18 (1945); Koch, Public Procedures for the Promulgation of Interpretative Rules and General Statement of Policy, 64 Geo. L. J. 1027, 1053-54 (1976). Koch recommends that the interest in public participation and the interest in administrative flexibility should be reconciled in the case of interpretative rules by use of "abbreviated public procedures tailored to particular situations . . . ," exactly what the Board has done in this case. In fact, the notice and public comment procedure followed by the Board in this case conforms in substance to the APA requirements for informal rulemaking.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ,  -43--  process, but is not controlling.  If the court determines the  rule "creates new law, rights, or duties," it will be held  to  be legislative in character...1/ An  interpretation  legislative rule  of  is clearly  an  a  term  in  a  statute  interpretative  or  rule.  in As  a the  Court stated in Batterton v. Marshall: An interpretative rule serves an advisory function explaining the meaning given by the agency to a particular word or phrase in a statute or rule it administers. As this court explained in Gibson Wine Co. v. Snyder, 194 F.2d 329 (D.C. Cir 1952): 'An interpretative rule is one which does not have the full force and effect of a substantive rule but which is in the form of an explanation of particular terms in an Act. If you had an expression in a statute such as "Interurban Railway," the query might come up as to what is an "interurban railway." particular A agency may adopt a rule defining an interurban railway. That, in a sense, may be called an interpretative rule.'/ Based interpretation  on  these  is an  principles, the  interpretative  the rulemaking procedures of the APA.  rule  Board  finds  that the  that is exempt from  First, the Board intends  22/ E.g., General Motors Corp. v. Ruckelshaus, 742 F.2d 1561, 1565 (D.C. Cir. 1984), cert. denied, 105 S.Ct. 2153 (1985); American Postal Workers Union v. United States Postal Service, 707 F.2d 548, 558-59 (D.C. Cir. 1983), cert. denied. 465 U.S. 1100 (1984). 23/  648 F.2d 694, 705 (D.C. Cir. 1980).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -44-  to adopt an interpretative rule views  on  the  meaning  of  Regulation G --  "indirectly  applied  situations  in  the  that sets forth  the  existing  secured  by  involved  Pantry Pride/Revlon transactions.  in  the agency's  provision  margin the  in  stock" --  Mesa/Unocal  as  and  The Board does not, and does  not intend to, create new law or impose new duties beyond those already contained in the existing Regulation.  Second, by its  terms, the interpretation merely expresses the Board's views on what "indirectly secured fact situations.  by  margin stock"  means  in  specific  The interpretation is not itself intended to  have, and does not have, any binding effect on the courts or carry the force of law.  The interpretation merely utilizes a  presumption that debt securities issued by a shell acquisition vehicle in certain circumstances are indirectly secured by the margin stock  of  the  that an affected lenders  are  in  collateral.  target company and  party  good  may provide  faith  not  expressly  additional  relying  on  recognizes  evidence  margin  stock  that as  § 207.112(f).  Thus, the interpretative rule fits squarely within the scope  of  the  Congressionally-sanctioned  exemption  from  the  public notice and comment rulemaking procedures as established by  Congress  conclusion  and  interpreted  would be a  matter  by  the  courts.  of considerable  Any  other  concern  to  the  Board with respect to its ability to carry out effectively its functions under the margin regulations and other delegations of administrative authority by the Congress.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -45--  In its administration of the margin requirements, the Board  has  relied  interpretations  extensively  and  advisory  various precedents relied that  the  interpretative  on  the  staff  practice  of  opinions.  issuing  In  fact,  upon by the commentators  rule  violates previous  are, in fact, in themselves interpretations,  the  in urging  Board  policy  mainly opinions  issued by the staff. If the interpretative rule adopted by the Board here is not an interpretative rule but a legislative rule, then the many other interpretations adopted by the Board and  the staff  in the past must also be legislative rules and would be invalid because they have been adopted without meeting the requirements of the APA for notice and public comment. logical point, but has  important  This is not merely a  consequences  for  effective  administration of laws delegating administrative authority to the Board, including those concerning margin requirements.  The  submission of all interpretative rules for public notice and comment would have severe effects on the administrative process and on the public's ability to operate effectively under these rules  and  regulations.  This  is  precisely  the  reason  why  Congress specifically provided that interpretative rules would not be subject to these requirements, and that  the  interpretative  rule  adopted  the Board believes  today  fully  meets  the  requirements established by law for interpretative rules. The that   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  the  Department  interpretation  of is  Justice a  and  Drexel  legislative  rule  Burnham because  argue it  •  -46-  effects  a  change  in  law  or  policy.  Some  courts  have  characterized agency action as a legislative rule if it changes existing policy by altering provisions of an already existing legislative rule.-24/ In this case, the Board does not believe it is altering existing policy or a legislative rule; rather it is interpreting a term in existing law with respect to a fact situation that has not been explicitly covered by the Board or the staff.  In any event, to the extent it might alter  anything, the interpretation may change a prior interpretation by the staff.  While  it may make good sense  to require that  changes in legislative rules be made only after compliance with public notice and comment, this rationale does not apply to an interpretative  rule  to  which  these  requirements  are  not  applicable. The Justice Department and Drexel  Burnham  claim  the  interpretation changes a legislative rule because it conflicts with the provisions secured"  (12  in  C.F.R.  Regulation G  § 207.2(f)(1)).  relating They  Regulation G requires some restriction on margin  stock  or  some  "arrangement"  to "indirectly suggest  the  between  that  disposition of a  lender  and  borrower as a prerequisite to a finding that indirect security exists.  24/  As explained above, the Board believes that in the  E.g., Gosman v. United States, 573 F.2d 31, 39 (Ct. Cl. 1978).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -47-  situation  described  in  the  interpretation,  there  restriction on the ability of the shell corporation of  margin  stock  of  the  target  company.  The  is  a  to dispose  Regulation  explicitly provides only that "indirectly secured" "includes" such  arrangements;  arrangements. made clear  it  is  not on  By longstanding  that a  of  limited  interpretation, the  result in  credit is indirectly secured  provisions  face  to  such  Board  variety of circumstances, not described  the Regulation, could  interpretation,  its  therefore,  Regulation G.  consistent with these rules.  a  finding  that a  has in  particular  by margin stock.' The Board's does On  not the  conflict contrary,  with it  is  the fully  Thus, the interpretative rule is  not a legislative rule on the basis that it changes the policy or rule contained in Regulation G.21/  25/ In 1981, the staff made clear that in certain cases at least credit extended to an investment company the assets of which consisted primarily of stock was indirectly secured by the stock. And the argument that credit extended in a tender offer context to a corporation with no assets other than margin stock could be indirectly secured by margin stock was noted even earlier in a legal analysis of the margin regulations. Herzel & Rosenberg, Loans to Finance Tender Offers: The Bank's Legal Problems, 96 Banking L. J. 676 (1979). 26/ Justice The Department also asserts that the interpretation would reverse prior staff opinions on whether publicly offered debt securities are subject to the margin regulations. Since the Board is deferring consideration of this issue, the Department's contentions on this question need not be addressed at this time.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -48-  The  Justice  interpretation  Department  effects  a  also  change  of  argues  policy  that  that  the  may  be  implemented only by legislative rule because the interpretatinn contemplates takeover effect  case-by-case  transactions.  of  perceived  the ad  Even  Board's hoc  Board  review  of  in  were  and  in  of  accurate,  administering  regulations clearly represents no change the Board's longstanding  financing  if this characterization  interpretation  approach  the  the  oi the  thc  margin  policy.  Indeed,  universally understood  practice  has been precisely to provide the informal guidance of eithe the  Board  or  particular involving  staff  facts the  on  a  case-by-case  presented,  financing  of  noted above, if the Board  basis,  including corporate  limited  those  to  situations  acquisitions.' As  were precluded from  expressing  views on the applicability of the margin regulations other than in  potentially  proceedings,  the  time-consuming effect  would  and be  to  costly  rulemaking  undermine  seriously  effective administration of the Act and seriously burden the who  are  subject  to  the  regulation.  The  objective  of  the  interpretative rule is, however, the same as that advanced by the  commentators --  to  reduce  the  need  for  administrative  opinions by carefully clarifying the scope of existing rules  27/ E.g., 12 C.F.R. Service 5 5-942.11.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  § 221.110;  Federal  Reserve  Regulatory  -49-  The Board is, in fact, responding to the various requests for interpretation of these rules. Comments submitted by the GAF Corporation contend that the Board's action is a legislative rule because it would have a substantial impact. the  proposal  presumption  made  by  contained  However, as GAF in  would the  noted  not  be  in  Section III. B.,  covered  interpretative  by  rule.  the More  generally, while the test of "substantial impact" on private parties has been employed by a few court s  to determine  if a  rule is legislative in nature, a growing numbe r of other courts and legal commentators reject the "substanti al impact" test on the  grounds  that  impact  is  not  relevant  to  the  standard  established by the Supreme Court for deciding whether a rule is legislative in nature -- whether the rule was  issued pursuant  to a delegated grant of rulemaking authority.  They point out  that some -28/ impact.  truly interpretative In  any  test, the Board's  event,  even  rules could under  interpretation  is  the  have  substantial  substantial  impact  not a legislative rule,  because it deals with a narrow class of finan cing transactions, and  merely expresses a rebuttable presumption that the Board  would view certain debt securities as subje ct to the  28/  E.g., Cabais v. Egger, 690 F.2d 234, 237 (D.C. Cir. 1982); Energy Reserves Group, Inc. V. Depar tment of Energy, 589 F.2d 1082, 1093-98 (Temp. Emer. Ct. App. 1973). In this case, the Court stated succinctly: "The weight of persuasive and controlling legal authorities does not suppo rt application of this substantial impact test." 589 F.2d at 1094.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  F  -50-  margin  regulations  "substantial enacted  by  when  impact"  particular  flows  Congress  and  from  from  facts  the  are  present.  margin  Regulation G,  Any  authorization not  from  the  interpretation of these rules adopted by the Board. B.  Need for Additional Public Comment  Although not required provided  notice  interpretation  and in  a  to do so by the APA, the Board  period  order  to  for  public  assure  that  comment  the  on  focus  the  of  the  interpretation would remain narrow and that unintended effects would  not  arise.  Several  commentators,  including  the  Department of Justice and the SEC, expressed the opinion that public policy considerations require the Board to follow more extensive procedures than those provided.  even  As noted at the  outset, the Board has had this matter under consideration since May 1985. affected  There  have  parties,  been  consultations  voluminous  briefs  and  have  been  extensive staff papers have been prepared for and the Board has reviewed  this  meetings  with  submitted,  Board  analysis,  matter on several occasions.  In addition, although not required by law, public notice has been given and public comment received and analyzed. The Board believes interpretations involved,  that  fairly the  that  apprised  the  record  the the  in  notice  of  the proposed  public  of  the  this  matter  has  issues provided  sufficient information to determine that the interpretation, as clarified,  would  not  have  unintended  effects,  and  that  additional factual development is unnecessary, since the ruling   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -51-  is limited to the specific facts presented. been  ample  opportunity  for  interpretative process, and  public  Thus, there h,  participation  in  the  although not required by law, in  substance the notice and public comment provisions of the APA have been fully met. Moreover,  the  additional procedures  Board  finds  that  is outweighed  by  the  benefit  necessity  of  provide  to  guidance to active financial markets and to remove promptly any uncertainty about the limited nature and scope of the Board's action.  Further  delay  will  allow  transactions  to  be  rescheduled to avoid the interpretation in derogation of fail_ and uniform administration of the margin law. VI.  APPLICABILITY TO EXISTING FINANCING ARRANGEMENTS Several comments address the Board's statement in the  request for  comments on the proposed  interpretation that, if  adopted, the proposed interpretation would not apply to written contracts to extend credit entered into prior to the effective date of the interpretation.  These comments asserted that since  the action is intended merely to provide the Board's views on the meaning of the term "indirectly secured by margin stock" in the  existing  regulations,  it  should  govern  all  financing  arrangements, regardless of when they were entered into. The Board recognizes that its action in  nature and  from  the  that, accordingly, any legal obligations arise  legislative  interpretation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  is interpretive  rule  being  construed  However, the Board  and  not from  also recognizes  that  the the  -52-  scope of "indirect security" as used in the margin regulation is not, as the Board has made clear (see 12 C.F.R. § 221.113(f)), capable of explained  precise above,  definition  the  Board  in  every  believes  situation.  that  While,  based  on  as  past  interpretations of that term the public should have been aware, prior to this action, that at least in some cases purpose credit extended  to  a  shell  acquisition  vehicle  could  reasonably  be  viewed as indirectly secured by margin stock, it is possible that some parties  could  have  in good  faith  relied  on  a  different  construction of the term as applied in acquisitions situations. The Board is of the view that a subsequent agency interpretation clarifying the scope of a potentially ambiguous regulation should not be applied retroactively to parties that were unaware of the Board's  constructions  interpretation.  of  the  Accordingly,  regulation in  the  prior Board's  to  the  view  agency the  interpretation adopted today does not apply to written contrac ts to extend  credit entered  into prior  to  this  date, January 8,  2_2/ 1986.  29/ The interpretation does not apply to financing commitments entered into prior to today, if they are subject only to the usual contingencies and conditions typical in financi ng agreements. In addition, the GAF Corp. has requested that the Board exclude from the interpretation any acquisitions by a company that held 5 percent or more of the target company's stock on the effective date of the interpretation. The Board is of the opinion, however, that such a provision is inconsistent with an action that merely provides the Board's views on the scope of a regulatory provision.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -53-  LIST OF SUBJECTS IN CFR PART 207 Credit, Margin Requirements, Reporting and Recordkeeping Requirements, Securities: Pursuant to the Board's authority under Sections 7 and 23 of  the Securities Exchange  Act of  1934, as  amended (15  U.S.C. 78g and w) the Board adopts the following interpretation and amends 12 CFR 207 by adding a new  § 207.112 to read as  follows: § 207.112--Purchase of Debt Securities to Finance Corporate Takeovers (a)  Petitions have been filed with the Board raising  questions as to whether the margin requirements in Regulation G apply  to  two  types  securities are  of  issued  corporate to finance  acquisitions the  in  which  acquisition  of  debt  margin  stock of a target company. (b) Company A,  In  the first situation,  controls a  the  shell corporation,  acquiring that  company,  would  make  a  tender offer for the stock of Company B, which is margin stock (as defined  in section 207.2(i)).  The shell corporation has  virtually no operations, has no significant business function other than to acquire and hold the stock of Company B, and has substantially acquired. would  no  assets other  the  margin  stock  to  be  To finance the tender offer, the shell corporation  issue debt securities which, by their  unsecured.  If  the  tender  corporation would seek   https://fraser.stlouisfed.org • Federal Reserve Bank of St. Louis  than  offer  is  terms,  successful,  to merge with Company B.  would  the  be  shell  However, the  -54--  tender offer seeks to acquire fewer shares of Company B than is necessary under state law to effect a "short form" merger with Company B, which could be consummated without the approval of shareholders or the board of directors of Company B. (c)  The purchase of the debt securities issued by the  shell corporation to finance purpose  credit"  addition,  such  (as  debt  the acquisition clearly involves  defined  in  securities  section  would  be  207.2(1)). purchased  In  only  by  sophisticated investors in very large minimum denominations, so that  the  purchasers  Regulation G.  See  may  12  be  "lenders"  C.F.R.  for  purposes  § 207.2(h).  Since  of  the  debt  securities contain no direct security agreement involving  the  margin stock, applicability of the lending restrictions of the Regulation  turns  on  whether  the  arrangement  constitutes  an  extension of credit that is secured indirectly by margin stock. (d)  As the Board has recognized, "indirect security  can  encompass a  and  borrowers  serve  wide variety of arrangements between lenders  with  to protect  respect  the  to  lenders'  margin  stock  interest  in  collateral assuring  that  that  a  credit is repaid where the lenders do not have a conventional direct  security  § 221.113.  interest  in  the  collateral.  See  12  C.F.R.  However, credit is not indirectly secured by margin  stock if the lender in good faith has not relied on the margin stock as collateral in extending or maintaining credit. C.F.R. § 207.2(f)(2)(iv).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  See 12  -55-  (e)  The Board  is of the view that, in the situation  described in (b) above, the debt securities would be presumed to be indirectly secured by the margin stock to be acquired by the  shell  acquisition  vehicle.  The  staff  has  previously  expressed the view that nominally unsecured credit extended to an investment company, a substantial portion of whose assets consist of margin stock, is indirectly secured stock. This  See Federal  opinion  substantially  notes no  Reserve that  assets  by the margin  Regulatory Service  the  other  investment than  margin  7  5-917.12.  company stock  has  to  indebtedness and thus credit could not be extended  support  to such  a  company in good faith without reliance on the margin stock as collateral. (f)  The Board believes that this rationale applies Lo  the debt securities issued by the shell corporation described above.  At the time the debt securities are issued, the shell  corporation has substantially no assets to support the credit other than the margin stock that it has acquired or intends to acquire and has no significant business function other than to hold the stock of the target company in order to facilitate the acquisition. the  Moreover, it is possible that the shell may hold  margin stock  for  a significant and  indefinite  period  of  time, if defensive measures by the target prevent consummation of  the acquisition.  Because of the difficulty in predicting  the outcome of a contested takeover at the time that credit is   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -56-  committed to the shell corporation, the Board believes that th-purchasers of the debt securities could  not,  in  good  faith,  lend without reliance on the margin stock as collateral.  The  presumption that the debt securities are indirectly secured by margin stock would not apply if there is specific evidence that lenders could in good faith rely on assets other  than  margin  stock as collateral, such as a guaranty of the debt securities by the shell corporation's parent company or  another  that has  or  substantial  This presumption  non-margin  would  stock  also not apply  agreement between the acquiring  and  assets if  there  company  cash is  a  target companies  into at the time the commitment is made to purchase  flow. merger entered  the debt  securities or in any event before loan funds are advanced.  In  addition, the presumption would not apply if the obligation of the purchasers of the debt securities to advance funds to the shell corporation is contingent on the shell's acquisition u, the minimum number of shares necessary under law  to  effect  companies  a  merger  between  merger  lenders  acquiring  without the approval of either  directors of the target company. the  the  applicable state  reasonably be  target  the shareholders or  In these two situations wherc,  will take place promptly, the Board  could  and  presumed  to  be  believes  relying  on  the the  assets of the target for repayment. (g)  In addition, the Board is of  the view that the  debt securities described in paragraph (b) above are indirectly   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -57-  secured  margin  by  stock  because  there  is  a  practical  restriction on the ability of the shell corporation to dispose of  the  margin  stock  of  the  target  company.  secured" is defined in section 207.2(f) of include any arrangement  under  which  the  "Indirectly  the regulation  to  customer's right or  ability to sell, pledge, or otherwise dispose of margin stoc;, owned by the customer is in any way restricted while the credit remains outstanding.  The purchasers  of  the  issued by a shell corporation to finance clearly  understand  acquire  the  effect  the  that  the  margin stock acquisition  of  of  shell the  a  debt  takeover  corporation  This  attempi  intends  target company  that company.  securities  in  to  order  t(  understanding  represents a practical restriction on the ability of the shell corporation  to  dispose of  the  target's  margin  stock  and  to  acquire other assets with the proceeds of the credit. (h)  In the second situation, Company C, an operat  company with substantial assets or cash flow, seeks to acquire Company D,  which  is  significantly  larger  Company C establishes a shell corporation Company C  makes a tender  which is margin stock. corporation  offer  for  the  than that  Company C. together  shares of  with  Company D,  To finance the tender offer, the sheli  would obtain a bank loan that complies  with  the  margin lending restrictions of Regulation U and Company C would issue debt securities that would not be directly secured by any margin   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  stock.  The Board  is  of  the opinion  that  these  debt  -58--  securities should not be presumed to be indirectly secured by the margin stock of Company D, since, as an operating business, Company C has substantial assets or cash flow without regard to the margin stock of Company D.  Any presumption  would  not be  appropriate because the purchasers of the debt securities may be relying on assets other than margin stock of Company D for repayment of the credit. Board January   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  of  Governors  of  the  Federal  Reserve  System,  1986.  William W. Wiles Secretary of the Board  I   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  December 31, 1985 TO:  Board of Governors  FROM:  Division of Banking Supervision and Regulation Legal Division  SUBJECT:  Summary of Comments  The full summary of comments, which  we noted  was  in  preparation in our memorandum to the Board of December 27, has now been completed and is enclosed.  The memorandum summarizes,  in  issues  categories  related  to  the  major  raised,  the  87  comments received from the public. Also  as  mentioned  staff analysis of Register  Notice,  Friday, January 3.  Enclosure   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  the will  in  the  December 27  issues, together be  distributed  with to  a  Board  memorandum,  a  draft Federal members  on  4   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  II  'L.J)  SUMMARY OF COMMENTS  PROPOSED INTERPRETATION OF REGULATION G  DOCKET NO. R-0562  /.  TABLE OF CONTENTS  NUMBER AND NATURE OF COMMENTS POLICY ISSUES FACTUAL AND REGULATORY ISSUES  8  PROCEDURAL ISSUES  25  COVERAGE ISSUES  31  GRANDFATHERING ISSUES  39  LIST OF COMMENTORS  41   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  NUMBER AND NATURE OF COMMENTS  As of the close of the comment period, there were a More than  total of 87 public comments.  the  were strongly supportive of  half of the comments  proposal, and  the  reflected  views of a broad spectrum of society, including 25 members of Congress, a number of small investors, Salomon Brothers, the Manufacturers,  National  Association  of  Business  Roundtable,  stock  firms,  and  Petroleum,  large  and  Unocal  Control  for  Foods  These  Data).  interpretation  small  a  Champion  of  the  brokerage Phillips  (e.g.  International Corporation  Corporation, Apache  commenters  number  AFL-CIO,  professionals,  corporations  Corporation,  Corporation, Universal and  market  the  favored  the  proposed  including (1) its  reasons,  probable effect of protecting small investors by discouraging risky investments by pension funds and other trustees, (2) its help in restoring integrity in the nation's financial markets, and (3) its etfect as a curb on speculation and the excessive use of debt for speculative purposes. Generally Drexel  Burnham  Securities  and  unfavorable  Lambert, the Exchange  comments  Department  Commission,  were of  as  received  from  Justice, and well  as  the  from  corporations currently engaged in takeover attempts, securities firms, and academics.  These comments reflected concerns with  respect to whether the Board had followed the proper procedure in issuing the proposed interpretation and took issue with the Board's public policy views on acquisition financing.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -2-  Some comments were neutral in nature, as they merely requested guidance with  respect to the applicability of  the  proposed interpretation to specific fact situations. The comments, both pro and con, addressed issues in the following general areas: (1)  The policy implications of the proposed interpretation;  (2)  Whether the proposed interpretation has any basis in tact; whether it is consistent with the purposes of margin regulation; whether it is consistent with prior Board and staff rulings; and whether it would put the Board in an unprecedented regulatory role;  (3)  Whether the Board had complied with the in Act Procedure Administrative proposing the interpretation;  (4)  situations certain Whether transactions would be covered proposed interpretation; and  (5)  What transactions would be covered by the grandfather provisions of the proposed interpretation.  and by the  A list of the commenters begins on page 41 of memorandum.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  this  , 3  I.  POLICY ISSUES The Board received comments from a broad  the public in support of its proposed  spectrum of  interpretation.  These  commenters included a number of private investors, the Natio nal Association Congress, brokerage policy  of  Manufacturers,  market  the  professionals,  firms, and  standpoint,  large  and  supporters  AFL-CIO,  the small  of  25  Business  members  Roundtable,  corporations.  the  proposal  of  From  argued  a  that  (1) it is a much needed step toward ensuring the integrity of the nation's financial markets; (2) it will help "cool off" the speculation  that has given constructive corporate acquisitio ns  a bad name; (3) it will discourage risky investment s by pension funds,  bank  trust  departments  and  insurance  companies  and  therefore protect the small investor; and (4) it will curb the excessive use of corporate debt. Banking They  Committee  believe  diverted  the  fully support recent  capital from  also concerned  the  proposed  junk uses.  increasing  bond The  interpretation. financing  has  Congressmen  are  rate of debt growth --the  bonds has increased  1983 to well over $100 billion that in order  of  productive  about the  amount of low grade  wave  Twelve members of the House  in 1985.  from $37 billion  in  The members believe  to ward off possible suitors, many corporatio ns  are taking on additional debt that they would otherwise shun, thus creating a disturbing trend in corporate finance.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -4The Justice Department and (FTC) argue  proposed  that the  financing  time, legal, and takeovers, and  that  interpretation  costs associated  Board  the  Federal Trade Commission  has failed  will  corporate  with  to  increase  identify  any The  benefits to be derived from adopting the interpretation.  Justice Department, the FTC, and Drexel Burnham Lambert (DBL) also argue that corporate takeovers are desirable and serve economically  useful purposes.  that competition for  The Justice Department states  corporate control, like other  competition, yields net social benefits.  Other commenters have  noted that these benefits include increased stock shareholders resources,  and The  more FTC  efficient notes  that  areas of  utilization corporate  prices for corporate  of  acquisitions,  including those resulting from hostile tender offers, have the potential to shift assets to higher-value uses, allow firms to realize  economies  ot  scale  and  distribution,  and  spur  managerial excellence. Other  commenters  believe  that  detract from a strong economic system. expressing support for  the  proposed  corporate  takeovers  A number of commenters discussed  interpretation  negative factors associated with corporate takeovers. The Business Roundtable objects  to accumulated  financing because the high debt service costs associated such  financing  causing   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  affects  management  to  managements' operate  in  a  ability risk  to  compete  adverse  debt with by  manner;  -54.  furthermore, accumulation  the of  Business  Roundtable  debt increases  the  argues  probability  that of  the business  failure, as did a number of other commenters who objected to the substitution of debt for equity on the balance sheets of an ever-increasing number of corporations. The Apache Corporation noted that the increased use of debt financing  is  unfair  to existing  credit impairment results in lowered debt prices, and greater risks. argues that: due  holders  because  credit ratings, lowered  On the other  hand, the FTC  'Actual bankruptcies are much more likely to be  operational  to  debt  inefficiency  which,  ironically,  implementation of the proposed interpretation encourages.. The  AFL-CIO notes that corporate takeovers are  not  necessarily done for productive purposes; in certain instances corporate takeovers can  operating loss credits rather AFL-CIO and  others  by persons seeking  be motivated  noted  than  instances  productive capacity. where  corporations  net The have  endangered themselves by issuing debt in the course of fighting off hostile tender offers.  Finally, the AFL-CIO argues that  new jobs are rarely, if ever, created  by takeovers and  that historically, many businesses are dismantled after  notes being  acquired. Furthermore, the National Association of Manufacturers and Dillion, Read & Co., Inc. both expressed concerns about the potential   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  negative  effects  of  excessive  leverage  in  the  -6-  The National Association of Manufacturers  securities markets.  argues that the interpretation is securities  to  subject  not  are  markets  necessary  to ensure  abrupt  that  distortions  because of excessive leverage in stock transactions. Shearson/Lehman American Express noted that leveraged buyouts  are  beneficial,  but  hostile  Accordingly, Shearson/Lehman and interpretation supported  not apply  should  leveraged  buyouts.  to  director  Shearson  and  argues  management in  that  will  not. that the  others recommended  that the shell  cases, there is little risk  are  takeovers  be  such  holding  margin stock for an indefinite period of time and more reliance will  be  placed  upon  the  assets  of  the  corporation  be  to  acquired., Merrill Lynch also made this recommendation. Some  proponents  of  the  diminished ability of smaller corporations corporations as a Company  views  positive  hostile  The  benefit.  takeovers  see  interpretation  as  an  the  to acquire larger Phillips  abusive  Petroleum  practice  by  corporate raiders in that the high amount of leverage employed allows them to operate with little or none of their capital at risk. Some commenters took issue with the premise upon which the interpretation is based, i.e., lenders rely on the stock held  by a shell corporation  containing  no other  assets and  established solely tor the purpose of obtaining control of a target corporation.  The Department of Justice and DBL argue  that purchasers of debt securities rely upon the cash flow and assets of the combined companies for   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  repayment--not upon the  7  stock of the company to be acquired. Furthermore, it is argued that lenders make their decisions based assets,  underlying  the  flow  cash  and  upon an assessment of likelihood  that  the  proposed acquisition will be consummated. On the other hand, many of the commenters who favor the interpretation express agreement with the Board's reasoning that investors purchasing debt securities  issued  by a shell  corporation do in fact indirectly rely upon the only assets of the corporation, i.e., margin stock. The Alliance for Capital Access (ACA) maintains that adoption  the  of  interpretation  could  discriminate  against  smaller companies in raising funds for growth and acquisition. The  ACA  stated  that  when  its  members  friendly acquisitions, they spend  seek  to  go  through  weeks working very carefully  with the management of the company to be acquired arranging the terms  of  the  transaction  and  interpretation  requires an  offeror  the  financing. to file  If  with  the  the Federal  Reserve for an opinion that the acquisition is not indirectly secured by margin stock, the delay in ACA's view could expose the  companies  in  question  to  companies that could raised  hostile  money much  bids  by  much  larger  more easily and  avoid  Regulation G.  Finally, ACA notes that many investors in  members'  securities  debt  responsibilities;  there  are  is  a  institutions fear  that  if  with these  its  fiduciary investor  institutions have any uncertainty as to whether purchasing such bonds would  result in  choose not to invest.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  legal  violations, the  investors  would  8  ALLEGATIONS THAT THE INTERPRETATIVE RULE HAS NO BASIS IN  II.  FACT, IS CONTRARY TO THE PURPOSES OF MARGIN REGULATION, IS INCONSISTENT WITH PAST RULINGS, AND PUTS THE SYSTEM IN AN UNPRECEDENTED REGULATORY ROLE  (a)  Factual basis for finding that lenders are looking to the stock rather than assets of the target  Regulation G applies to credit extended for the purpose of purchasing or carrying margin stock ("purpose credit") if the credit is secured, directly or indirectly, by margin stock.  The law firm of Sullivan & Cromwell agreed with the Board's position that there was a basis in fact for finding that lenders are Jookina to the stock of the target for repayment.  Sullivan &  Cromwell supported this contentions by citing the case of GAF's current attempt to acquire Union Carbide, in which there is no question that holders of GAF notes (junk bonds) will look to Union Carbide common shares (margin stock) for repayment.  This  reliance on Union Carbide's shares, in Sullivan & Cromwell's view, constitutes "indirect security" under the margin regulations.  Dillon, Read believes that from a practical standpoint, so called "junk takeover bonds" are indirectly secured by the stock of the target corporation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  9  The Unocal Corporation stated that by recognizing that economic reality determines whether a junk bond loan is "indirectly secured" within the meaning of Regulation G and by presuming that the margin rules apply to junk bonds issued by a shell corporation, the Board has taken a big step toward putting an end to the evils engendered by the current junk bond financed takeover craze.  Those evils - the creation and fostering of  speculative fever in the stock markets, the diversion of credit from productive uses, and the growing trend toward dangerous over-leveraging by American corporations - are in Unocal's view, the very evils that the margin provisions of the Securities Exchange Act were designed to prevent; and by requiring takeover attempts to be financed with more equity and less debt, the Board's interpretation will make it that much more likely that takeover contests will be decided on their economic merits.  Twelve members of the U.S. House of Representatives stated that it clearly strains credibility to argue that junk bond lenders are not relying on the target company's stock as the primary source of repayment, since the issuer's assets, net worth and income could not possibly support the debt incurred.  In opposing the Board's proposed interpretation, some commenters argued that purpose credit used to effect corporate acquisitions through the vehicle of junk bonds is not indirectly secured by the underlying assets of the target corporation.  A  finding of such indirect security is the basis for the Board's   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  10  cings. applying Regulation G to junk bond finan  The commenters  al junk bonds are not looking believe that the purchasers of typic acquired as the source to the margin stock of the company to be earning power of the of repayment, but rather to the assets and letters from Profestarget once the merger is consummated. (See Management; Thomas H. sor E. Allen Jacobs, MIT Sloan School of rs, NYSE; Cohen Feit Lee Company; Kellner DiLeo Partnership, Membe am Lambert; Hyponex & Co; Caronan Partners; the SEC; Drexel Burnh y/Northwest Corporation; Rosencranz & Company; EF Hutton; Farle Industries, Inc.).  Merrill Lynch and others argued that the  called "good proposed interpretation would undermine the so ity insofar as it faith" exception to a finding of indirect secur t that credit would establish a negative presumption to the effec n stock would be extended to a shell corporation to purchase margi G. viewed as a covered transaction under Regulation  over The Department of Justice believes the concern Regulation G is stock-secured credit that lies at the heart of firms engaged in inapplicable to acquisition financing in that of the target takeovers are really looking toward acquisition company's assets, not its stock.  the Related to this issue is Justice's concern that y and thereby proposed interpretation would create uncertaint impose substantial costs on all acquiring firms.  Under the  t will be deemed Board's proposed interpretation, a purpose credi the debt indirectly secured by margin stock if "at the time   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  11  securities are issued, the shell corporation has substantially no assets to support the credit other than the margin stock that it has acquired ... and has no significant business function other than to hold the stock of the target company in order to facilitate the acquisition."  The Justice Department believes  this language will cause uncertainty if the shell corporation has some other assets or some other business functions.  It also asks  how one would determine whether those assets are "substantial" or the business functions "significant."  Other examples of  uncertainty pointed out by Justice relate to what constitutes "specific evidence" which would rebut the presumption that junk bond credit is indirectly secured by margin stock.  Justice  believes that one of the most significant unresolved questions is whether the Board proposes to apply Regulation G to operating companies on the basis of fixed ratios of debt to income or asset value, and if so, what those ratios are.  If ratios are not  proposed, Justice asks if the Board will use other standards. Justice believes that the business community must be informed of the Board's position on these issues prior to implementation if the market for corporate control is to function in an efficient manner.  The Securities and Exchange Commission questioned the appropriateness of the proposed interpretation's presumption that those who lend to acquirors in fact look to the stock of the target as collateral.  In the SEC's view, lenders may actually be  looking to the assets of the company to be acquired for security,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  12  rather than to its stock.  The Commission believes this issue  warrants further analysis.  (b)  Reconciling the interpretation with prior staff opinions.  The law firm of Sullivan & Cromwell believes the proposed interpretation is entirely consistent with the prior Board and staff views in the analogous situation of loans to investment companies which were found to be indirectly secured by margin stock since the only assets of an investment company, like those of a shell corporation, are the shares of stock which it owns.  Midcon Corporation also believes the proposed interpretation in consistent with past interpretations.  Midcon states that  the Board has repeatedly held that loans are "indirectly secured" by margin stock if credit is extended to a shell corporation which holds securities and nothing else.  In Midcon's view, the  proposed interpretations should come as a surprise to no one in light of the Board's prior stance, the published views of practitioners, and court decisions to the effect that loans can be indirectly secured by stock without the presence of any traditional security interest.  Since the Board's release simply  reiterates past law on this subject, Midcon contends that it is impossible to accuse the Board of fashioning a new and unforseen legal standard.  Some commenters believe that the proposed interpretation is contrary to prior staff opinions. (Merrill Lynch; Kellner DiLeo;   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  13  Caronan Partners; the SEC; Drexel Burnham Lambert; the Department of Justice)  These commenters generally state that the Board's  proposed interpretation ignores the administrative precedent established by prior staff rulings which appear to conclude there is no indirect security involved in junk bond financing.  Drexel  Burnham Lambert (Drexel) believes that prior Board staff letters reached the conclusion that loans to shell corporations would not be indirectly secured by margin stock within the meaning of Regulation G and that the margin requirement was inapplicable. Drexel states that the basis of these letters and opinions is that a shell corporation organized to facilitate the acquisition of another company resembles a holding company, which the Board has concluded is not presumptively subject to margin rules because the purchaser owns the stock of the target with a view to operating a going concern.  In Drexel's view, this "holding  company" model has been distinguished from the "investment company" model upon which the Board has relied in its proposed interpretation.  Drexel believes that the Board's reliance on the  investment company model as a basis for its rationale rather than the holding company model relied upon previously in several opinions cited by Drexel is inappropriate.  The Department of Justice believes the proposed interpretation constitutes an arbitrary rejection of prior staff rulings which, among other things, hold the view that purchasers of debt securities in public distributions are not "lenders"   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  14  within the meaning of Regulation G.  In this regard, Justice  points to recent litigation in which a court, relying on prior Board staff interpretations, ruled that public debt offerings are "exempt" from Regulation G,  basing its ruling on prior Board  staff interpretations. Justice believes the proposed interpretation's apparent "reversal" of such precedent reflects a fundamental shift that the Board should have afforded the lengthier notice and comment period provided for in the Administrative Procedure Act for formal rulemaking.  The Justice Department also believes that the proposed interpretation is inconsistent with the Board staff's prior opinions indicating that debt offerings of shell corporations formed to effectuate takeovers are not directly or indirectly secured by margin stock in the absence of agreements legally restricting the borrower's right to dispose of the stock.  (c)  Reconciling the interpretation with the purposes and intent of the Board's margin authority  Some commenters argued that the proposed interpretation is contrary to the purpose and intent of section 7 of the Securities Exchange Act of 1934, which gives the Board authority to promulgate the margin regulations.  (Kellner DiLeo; City Capital  Corporation; EF Hutton; Department of Justice; and Federal Trade Commission).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Generally, these commenters believe that the  15  application of the margin rules to tender offers for public companies do not carry out the purposes of Congress in enacting Section 7, which were to curb speculation in the stock markets and to prevent the destabilization of stock prices.  The law firm of Sullivan & Cromwell believes that the relevant question is not whether the margin regulations should be used to regulate takeovers.  Rather, the question is whether a  transaction which subverts the basic purpose of the margin regulations should nonetheless be exempt merely because it involves a takeover.  Sullivan & Cromwell recognizes that the  Board has recently considered its continuing role the area of margin regulation and whether  the regulations are necessary to  effectuate the purposes for which they were originally imple-mented.  Sullivan & Cromwell believes, however, that until the  Board determines to change the overall scope of the regulations, they must apply equally to all transactions covered by their terms.  The law firm noted that the broad issue of the general  usefulness of the margin regulations was raised by the Board at a time when relatively limited debt was being used to finance stock purchases and prudent business considerations constrained its use and that the situation has changed drastically within the last 18 months, as billions of dollars of debt are pouring into the market to finance takeover transactions.  City Capital Corporation argues that the margin rules were enacted to protect unsophisticated investors and the securities   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  16  markets from excessive speculation and that any attempt to graft an anti-takeover purpnse onto what is principally a retail credit provision should be approached with substantially more study and input from the business community.  EF Hutton pointed out that in his January 11, 1985 letter to Members of Congress, Chairman Volcker identified the three primary objectives of the margin rules; i.e., to constrain the diversion of credit into stock market speculation from uses in commerce, industry and agriculture; to protect unsophisticated investors; and to forestall excessive price fluctuations in the stock market.  Hutton believes the Board's proposal accomplishes  none of these ob-iectives, since the credit extended by purchasers of junk bonds is not used for speculative purposes, but for effectina business combinations.  In addition, Hutton points out  that lunk bond purchasers are extremely sophisticated investors, capable of judging credit risks without the help of the Board.  Drexel Burnham Lambert argues that the proposed interpretation is an unwarranted expansion of the Board's margin authority and that it encroaches on other Congressional prerogatives, namely the Williams Act and the Hart-Scott-Rodino Act.  Drexel  points out that the Williams Act was adopted by Congress to insure that investors faced with tender offers and other substantial acquisitions of securities would receive full and fair disclosure of all facts necessary to make informed investment decisions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Drexel stated that Congress plainly intended the  17  disclosure provision of the Williams Act to provide a neutral scheme that favored neither the offeror nor incumbent management of the target company.  Drexel also argues that the Hart-Scott-  Rodino Antitrust Improvements Act of 1976, which requires advance notification to the FTC of substantial stock acquisitions, also expresses a Congressional desire for neutrality in takeover bids. Drexel believes that the Board's proposed interpretation would frustrate this neutrality because in Drexel's view, the interpretation"would assist target companies by eliminating tender offers financed by acquisition subsidiaries' issuance of debt and would also tend to favor inefficient incumbent management. Midcon, on the other hand, stated that the Williams Act expresses a federal policy of "neutrality" toward tender offers -- not an affirmative preference for tender offers that overrides other federal statutory policies. The Department of Justice believes the proposed interpretation is an ineffective means of serving any of the concerns at which Congress directed Section 7 of the Securities Exchange Act of 1934.  Justice believes that unless the Board can  relate is proposed view of acquisitions by operating companies to the Congressional concerns that underlie Section 7, it is not clear that Section 7 gives the Board the authority to impose margin requirements on the basis of its evaluation of the financing arrangements with respect to individual acquisitions. Justice cited the findings of a recent Board staff study on the margin regulations indicating that the rules were not   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  F 18  effective or necessary to meet the objectives of the legislation. In light of this study, Justice believes it would be anomalous for the Board to assert that expanding the scope of its margin requirements meets those Congressional concerns.  Justice  believes that in any event, the Board could not assert such a public benefit from its proposed expansion of Regulation G unless there is evidence that the transactions covered by its proposal were diverting credit into stock market speculation and away from investment in commerce, industry or agriculture, harming unsophisticated investors, or creating excessive price fluctuations in the stock market.  Justice is unaware of the  existence of any such evidence, does not believe the Board's notice addresses such concerns and points to Chairman Volcker's January 11, 1985, letter to Members of Congress as a measure which undercuts any reliance on these effects.  The Federal Trade Commission believes the purpose of the margin requirements is not to protect borrowers against imprudently taking on too much debt, but to protect lenders, primarily banks and other financial institutions, against the risk of customer default.  The FTC believes that in the case of  corporate debt, there would appear to be no basis for concern about the magnitude of the default risk assumed by an individual lender.  The FTC stated that if the proposed interpretation is  designed to protect individual borrower firms against imprudently assuming too much default risk as a consequence of "excessive" leverage, it appears to be an unprecedented and ill-conceived departure from what the FTC views as the traditional focus of   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  19  margin requirements -- the maintenance of lender solvency.  The  FTC believes the best judge of the level of debt a given company should be permitted to incur is the credit market, not the Board. The FTC does not believe governmental interference with credit markets is warranted in the area of corporate acquisitions.  (d)  The effect of the interpretation on the Board's regulatory role  Thirteen United States Senators expressed their view that it is entirely appropriate to subject junk bond financing to the Board's margin requirements. (See joint letter from Senators Domenici, Dodd, Dixon, Stafford, Ford, Murkowski, Proxmire, Eagleton, Weicker, Boren, Sarbanes, and Nickles, December 20, 1985, a letter from Senator Gorton and a joint letter from twelve Members of the House Banking Committee, December 23, 1985).  The  Senators were concerned, however, that the Board's proposed interpretation may not be explicit enough.  In the Senators'  view, the Board's interpretation should not be circumvented merely by the parent of the shell corporation guaranteeing the junk bonds or by issuing the junk bonds directly when the stock to be acquired is relied upon as security by the holders of the junk bonds.  The Senators suggested that the Board make this  point very clear when it adopts the interpretation.  The Senators  pointed out that the Congress has delegated to the Board the authority and the responsibility to adopt and interpret the margin rules and that until and unless the statutory basis for the rules is altered by the Congress, or the text of the rules is   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  20  changed in a procedurally proper way by the Board, the existing margin rules remain in effect, and the Board must interpret and apply them in accordance with their terms and purposes.  In their  view, it would be an abdication of the Board's statutory and regulatory responsibility to fail to adopt the proposed interpretation.  Midcon rejects the assertion that the proposed interpretation will embroil the Board in complex factual questions and encumber the tender offer process.  The legal principles  applicable to shell companies are, in Midcon's view, the same legal principles which the Board has applied for decades in closely related contexts.  Midcon believes there is no basis for  concern over the definition of "shell corporation"  A corporation  that has no sbustantial assets or earnings of its own, and which can obtain credit only by virtue of the margin stock which it seeks to acquire, is the focus of the Board's interpretation. The standard applicable to "operating companies" is the same standard which now appears in 12 C.F.R. 207.2(f)(i), and could not engender any litigation complexities not already present in the law.  Beyond this, Midcon asserts that there is no need for either the Board or the SEC to serve as the arbiter of the application of the margin regulations in doubtful cases.  Midcon  suggested a private implied right of action will permit parties to seek injunctive relief in court in cases involving genuine disputes over the applicability of the margin requirements.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  And  21  from time to time, as it has done for decades, the Board may continue to issue interpretative releases as they prove to be necessary to illuminate recurring legal questions.  Other comments were received to the effect that the proposed interpretation would result in the Board's assuming an unprecedented regulatory role in the area of corporate acquisitions.  (Fred S. McChesney, Associate Professor, Emory  University School of Law; Carl L. Reisner, Esquire; Mesa Petroleum; Drexel Burnham Lambert; Alliance for Capital Access). These commenters generally expressed the opinion that the adoption of the proposed interpretation would cause the Board to involve itself in a new area of regulation where it does not belong.  Carl L. Reisner is concerned about the Board's apparent  case-by-case approach to regulation in this area and the lack of any concrete guidance about the circumstances in which Regulation G will apply.  He believes that such an approach will lead to  legal uncertainty which lenders and borrowers should not have to face in large transactions.  Mr. Reisner believes that the Board  will find itself increasingly drawn into contested takeover battles if the proposed interpretation is adopted and that the case-by-case approach will invite the possibility of disparate treatment and increased transaction costs.  Fred S. McChesney does not feel it necessary for the Board to move into an area which he believes is outside its expertise, and an area that is already scrutinized closely by the SEC.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  S 22  The Department of Justice believes the proposed interpretation constitutes a substantial change in Regulation G's application and would "drastically" expand the Board's power and add a new intrusive layer of regulation to the market for corporate control regardless of whether transactions are 'friendly' or 'hostile'."  It appears to Justice that the Board  contemplates playing an active role, on a case-by-case, in reviewing the financing of takeover transactions.  Justice  believes that as a result, the Board could be perceived as a regulator of takeovers, in which role it would decide which companies attempting to finance takeovers had "enough" assets other than margin securities to quality for exemption from Regulation G.  Justice believes the Board interpretation would  invite litigation by any party unhappy with the transaction and also have a chilling effect on extensions of credit.  The Securities and Exchange Commission believes the proposed interpretation creates uncertainties with respect to its application; i.e., what is a "shell" corporation, and what relevant "circumstances" and "specific evidence" will the Board consider in determining whether a lender has relied upon margin stock as collateral.  In the Commission's view, these  uncertainties could result in the Board's or the Commission's having to review a large number of acquisitions, at the request of either party in a takeover attempt.  This review would focus  on the "highly abstract" issue of whether the value of the company to be acquired could be argued to be the basis for the   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  23  extension of credit or whether the securities or assets of that company are, in fact, the collateral.  The Commission does not  believe the Board intends to embroil itself in such controversies and is concerned that its own role as the enforcer to the margin regulations could be unduly complicated, and its ability to secure prompt and consistent remedies for violations frustrated.  (e)  Other Issues (i)  Exemption for Short-Form Mergers  The Committee on Securities Regulation of the Association of the Bar of the City of New York believes that the proposed interpretation should exempt from its terms those transactions involving so-called "short form mergers" since lenders typically would not be relying on the stock of the target for repayment. State corporation laws generally contain provisions permitting a corporation owning a requisite percentage of the shares (usually 90%) of another corporation to merge the latter with the parent corporation without any action by the board of directors or shareholders of the owned corporation.  The Committee believes  that a lender extending credit to finance a tender offer that is conditioned on receipt of the percentage of shares of the target corporation required under state law to permit the acquiring corporation to cause a merger could in good faith rely on the assets and earnings of the target as support for the credit.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  24  (ii) The Proposed Interpretation Does Not Apply to Foreign Borrowers Who Use Foreign Credit Sources, and Therefore Provides Them with an Advantage Over U.S. Persons Subject to the Margin Requirements  Several commenters pointed out that because the margin regulations do not apply to foreigners who borrow from non-U.S. sources, the proposed interpretation would effectively provide such persons with an advantage over U.S. bidders, (Drexel Burnham Lambert; the SEC; Department of Justice; Rosencranz & Company; Hyponex Corporation; Caronan Partners; Merrill Lynch). The commenters are concerned that the interpretation could result in an increase in foreign ownership of domestic companies, and discriminate against potential domestic acquirors who would otherwise issue junk bonds to finance corporate acauisitions.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  25  III.  PROCEDURAL ISSUES (a) Overview Less than  a  third  Board's procedures for  of the letters commented  adopting  the  proposed  on  the  interpretation,  including comments submitted by the Department of Justice, the Securities and Exchange Commission and Drexel Burnham. A significant number of commenters (25 members of Congress, the law firm of Sullivan & Cromwell, Midc on Corporation, and Dillion, Read & Co.) believe that, as a procedural matter, the Board acted properly in issuing its proposed interpretation. Eight letters (including the Depa rtment of Justice, Drexel Burnham and GAF Corp.) suggest that the Board's proposed interpretation  represents  a  change  in  law  or  policy  which  requires the Board to act under the rulemaking procedures .of the Administrative Procedure Act ("APA"). Eleven letters (including the Securities and Exchange Commission and the Commodity Futures Trading Commissi on) comment that the proposal raises complex and important issu es and, as a policy matter, suggest the advisability of exte nded notice and comment procedures to permit additional time for public comments as well as additional time for the Board to consider the issues raised by the comments. (b)  The Administrative Procedure Act (APA) The law firm of Sullivan & Crom well stated  that the  proposed interpretation does not represent a change in the law, but merely clarifies that debt secu rities issued by a shell   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  26  corporation indicated  that  secured.  indirectly  are  as  an  such,  &  Sullivan  interpretation  Cromwell proper  the  is  administrative approach. that is the target of a  MidCon Corp., a corporation  with  be financed  hostile tender offer that would  bonds,  Junk  comments that the Board's clarification of Regulation G should be  "promptly  finalized."  points  Midcon  that  out  the  Administrative Procedure Act (APA) makes clear that the notice and comment provisions do not apply to interpretive rules such Midcon  as the Board's proposed clarification of Regulation G.  stated that at any rate, the Board has had the full benefit of public comment on its proposed received  hundreds of  literally  interpretation because it has pages  Midcon  contending that the  believes  Board  that  has acted  there  is  both  from  analysis  interpretation.  supporters and opponents of the circumstances,  of  these  Under  no  basis  without considering  for the  views of interested members of the public. The Department of Justice concludes that the proposal is legislative  rather  than  Board's  interpretative, and  that  the APA notice and comment procedures must be followed, which would  require  Board's  an  proposal.  extension The  of  the  Justice  comment  Department  period  for  acknowledges  the that  interpretative rules are exempt from the APA notice and comment procedures, but disagrees that the Board's proposal is only an interpretation  of  the  existing  regulation.  The  Justice  in Department believes that the interpretation effects a change   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  27  legislative  existing  tne  legislative  rule.  The  points to demonstrate changes  the  existing  rule  and, therefore, is  Department  that the  of  Board's  legislative  Justice  itself  raises  a  three  proposal expands and  regulation  and,  therefore,  must be adopted in compliance with the APA requirements. First, the Department of Justice notes that Regulation G  would  become  applicable,  under  certain  publicly offered debt securities. concludes that a  The  consistent series of  circumstances,  Department of  to  Justice  Federal Reserve  Board  staff opinions have stated that purchasers of publicly offered debt  securities  Regulation G.  are In  not  "lenders"  addition, the  within  the  Department of  meaning Justice  of notes  that recently, the Federal District Court in Delaware relied on the staff opinions in  ruling that public debt offerings are  "exempt" from Regulation G.1/ Second,  the  Department  of  Justice  notes  that  the  proposed interpretation would also effect a substantive change in  the  regulation's  secured."  existing  definition  of  "indirectly  The Department of Justice asserts that, presently,  the regulation provides that a loan is indirectly secured only it the loan agreement includes some legal restriction impairing the borrower's rights as owner of the stock.  The Justice  1/ Revlon, Inc. v. Pantry Pride, Inc., Fed. Sec. (CCH) V 92,348 (D. Del. 1985).   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  L.  Rep.  28  Department concludes that the new interpretation proposes a new test--whether there is a practical restriction upon the ability of the shell corporation to dispose of the margin stock of the target company. proposed would  The Department of Justice concludes that the  rule would extend the coverage of  constitute  an  abrupt,  substantive  Regulation change  in  G and the  well-estaolished policy governing the use of debt securities in takeovers. Third,  the  extension  of  S.- rating  companies  Department  Regulation on  suostantial change in Department  of  asserting  of  existing  by  the law,  a  to  Justice  debt  securities  case-oy-case  the application states  that  notes  basis of  the  that  issued would  be  Regulation  G.  Board  seems  to  the by a The oe  to engage in ad hoc review of debt-financed  eSr  acquisitions aspect  Justice  G  of  operating Board's  but  companies and  proposal  instead  adds  does a  new  concludes  not  merely  intrusive  that  this  "clarify" layer  ot  regulation to the market for corporate control and drastically expands the Board's power. (c)  Public policy considerations Dillion, Read & Co., Inc., believes that oecause the  interpretation is carefully crafted aouse,  it  is  unlikely  to  have  to  deal  signcant  with  a  specific  unanticipated  cS nsequences, as claimed oy opponents of the proposal.  Twelve  United States Senators ana twelve members of theHouse of Representatives suggested that the Board is compelled to issue   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  29  the  proposed  interpretation  until  and  unless  the  statutory  basis for the margin rules is altered by Congress ana that the proposed  interpretation  authority  delegated  to  is  merely  a  lawful  exercise  the  Board.  A  number  of  of  commenters  suggest that sound public policy dictates that the Board allow significantly longer periods for the submission of comments and for consideration by the Board of the comments submitted.  For  example, the Securities and Exchange Commission suggests that, at a minimum, the proposed interpretation should be republished to provide adequate time for careful consideration and of the implications of that  the  17-day  the  comment  proposal.  period  has  The  Commission statiks inadequate,  been  example, to assure that the interpretation unanticipated effects. raises complex appropriate  to  factual issues, for presume  that to  will not have any  the  example:  whether  purchasers  the stock  acquired as collateral; and  whether  of  there  of  the  the  suggests  that  these  further study which could existing comment period. proposal  could  have  a  questions  are  not be done  and  any  debt  the  be  the stock.  others  within  is  practical  require proposal's  Also, the Commission notes that the number  of  substantial  economic  consequences that have not been adequately explored.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  it  company to  restrictions on the shell's ability to dispose of SEC  for  The SEC also notes that the proposal  securities in fact look  The  review  30  Similarly, tne  Commodity  Futures  Trading  Commission  comments that it has not had time to study the Board's proposal in  detail.  The  CFTC seeks  a  thirty-day  extension  of  the  comment period so that the Commission will have the opportunity to consider the proposal.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  31  IV.  COVERAGE OF THE PPOPOSED INTERPRETATION  (a)  Applicability to banks (Reg U) and brokers (Reg T)  Alliance for Capital Access wants to know if the Board will tolerate an acquiring company's arranging for a shell company to borrow 50% of the accuisition funds from Regulation G lenders, pledging to them all of the acquired stock, while borrowing the balance of the acquisition funds from banks on an ostensibly unsecured basis. Drexel Burnham Lambert says the interpretation fails to identify how it will affect the interrelationship of Regulation G with Regulations T and U.  If the interpretation applies to T,  will the public/private offering distinction remain?  Will  broker-dealers be precluded from dealing in public debt securities? The California Bankers Association is concerned with the situation where a natural person, a customer of the commercial bank, applies for a loan for the purpose of purchasing junk bonds.  CBA fears that inadvertent violations of Regulation U may  occur. Merrill Lynch expresses concerns that a broker-dealer involved in the various stages of each takeover attempt will have to determine whether its purchase or sale of the bonds might constitute an unlawful arrangement of credit in violation of Regulation T.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  32  (b)  Applicability to friendly takeovers  Caronan Partners requests that the interpretation not apply to a friendly acquisition where there is a signed merger agreement that provides for a first-step tender offer. Drexel Burnham Lambert says the interpretation will affect friendly takeovers ("virtually every acquisition involving the issuance of debt"). Farley/Northwest Industries opposes the Board's interpretation because of concerns that it will have an adverse effect upon companies involved in friendly transactions where tender offers are used. The Thomas H. Lee Company states that companies engaged in the issuance of high-yield debt securities to finance acquisitions will be directly and significantly harmed by the Board's interpretation. misconceptions. will be financed  The Board's interpretation is based on  Investors purchase these securities because they assets and earning power of the target.  The  high rate of interest merely reflects the new more highly leveraged capital structure. Carl Reisner comments that the interpretation should be revised so that borrowing will not be deemed to be indirectly secured where an acquisition is made to facilitate a merger of the borrower and the issuer of the margin stock, even if this requires a two-step process.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  33  (c)  Applicability to one step mergers or leveraged buyouts  Caronan Partners requests that the interpretation not apply to a hostile tender offer conditioned on acquiring sufficient control to force a merger under state law. Caronan Partners also asks for a clarification that the interpretation does not apply to the usual leveraged buy-out situation. F F Hutton feels that leveraged buyouts could be severely restricted, as well as traditional methods of business combinations such as acquisition by a newly formed subsidiary. Alliance for Capital Access asks if the interpretation applies to leveraaed buyouts. Carl Reisner says the interpretation should not apply in one-step mergers.  It should also not apply when the funding is  conditioned on the borrower's obtaining sufficient voting power to effect the merger, and the borrower does obtain such power. In this case the lender is looking to assets, not stock. Merrill Lynch questions whether one step tender offers are intended to be covered by the proposed interpretation.  Depending  upon the structure of a transaction, it is possible that the shell corporation formed to facilitate an acquisition would hold the stock of the target company for at least an instant. Technically, such transactions would be covered by the proposed interpretation.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  34  (d)  When does the shell have substantially no assets other than margin stock?  Mesa Petroleum questions what is a shell corporation.  Will a  shell with a large dollar amount of equity contributed by a parent but no other operating assets fall under this new interpretation?  The Securities and Exchange Commission finds the shell corporation concept unduly broad and ill-defined.  The SEC feels  that income is not a relevant consideration and suggests a focus on assets and cash flow. Drexel Burnham Lambert says this is a crucial question left unclear by the Board's proposal.  (e)  Is an operating company a shell if the amount of debt dwarfs its size  City Capital Corporation finds this aspect to be the most dangerous.  The fact that the Board hints at a case-by-case  approach was said to benefit only entrenched management and their lawyers. Drexel Burnham Lambert says the rule appears to apply if the target has substantial assets relative to the acquirer, and that the case by case approach is unsuitable in the market. Unocal Corp. suggests that the interpretation be extended to cover junk bonds issued by or guaranteed by operating companies   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  35  where the economic reality indicates that the bonds are indirectly secured by stock of the takeover target. Merrill Lynch indicates that given the uncertainty as to what the Board regards as substantial, it is likely that the proposal will have an adverse effect upon the ability to structure transactions with the assurance that the margin regulations will not be applied.  (f)  Can a partnership or an employee trust ever be a shell  Mr. Terry Larkin raises the question whether such a proposal would affect buyouts by employees of corporations.  (a)  What is meant by a guaranty  Control Data Corporation states that the Board should interpret the regulation broadly so that speculators cannot easily evade it.  Simply guaranteeing the junk bonds or putting  modest assets into the shell should not necessarily be enough to avoid falling under the interpretation. Phillips Petroleum Company comments that a guarant  of the  shell corporation must be from a company whose size is substantial in relation to the size cf the obligations being guaranteed. Sullivan & Cromwell believes that a guaranty is inadequate if the amount of debt to be incurred exceeds the assets and   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  36  exceeds the shareholders' equity by substantial multiples, and the debt service exceeds the previous year's net income by substantial multiples. Cohen Feit & Co. wants to know circumstances other than a guaranty which will rebut the presumption that  bonds are  indirectly secured by margin stock. Hogan & Hartson (on behalf of GAF) seeks clarification that the interpretation does not apply where the debt is issued or guaranteed by an operating company with substantial non-margin stock assets and earnings in spite of Paragraph (h) of the interpretation. Alliance for Capital Access asks how a third-party guaranty or credit support of a shell company will be treated. Mesa Petroleum asks if a guaranty by an operating subsidiary of the parent will suffice. Gallagher and Beaumont suggests that the interpretation should specify the types of qualifying guarantee arrangements which would put the transaction outside the scope of the Regulation.  For example, they queried whether a third-party  guaranty from an insurer or other financial institution, procured by or on behalf of the parent, or which supports a direct guarantee from the parent, would suffice in putting the acquisition outside the Regulation.  (h)  Guaranty by parent is itself a loan  13 U.S. Senators believe that the Board should make clear that if the target stock is being relied on in any way, a   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  37  guaranty by the parent is not enough to avoid the interpretation, nor would having the parent issue the debt be sufficient.  (i)  Applicability to debt securities traded in secondary market  Merrill Lynch suggests the Board consider the regulatory implications of secondary market transactions in such bonds before the takeover and merger of a target company are consummated.  A purchaser in the secondary market might not have  the disclosure documents required by the Securities Act of 1933. In addition, they question whether this secondary market transaction would constitute a transfer of credit within the meaning of 12 CFR Section 207.3(1).  (j)  Other issues  The National Association of Manufacturers romments that in the case where a large percentage of stock continues to trade for some time after the tender offer, the risk of large liquidations causing a destabilizing effect on the stock is areater where the shell has little or no equity capital. The Securities and Exchange Commission comments that Paragraph (h) of the interpretation suggests that the Board may extend the application of the shell margin rules to acquisition financing beyond the shell corporation situation without delineating the relevant circumstances.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  38  The Coddington Corporation is concerned about the effect on insurance companies.  State regulations often prohibit insurance  companies from incurring debt, necessitating a holding company structure.  The holding company has only stock to pledge while  other corporations can pledge assets and thus avoid the interpretation. City Capital Corporation says the the fact that the stock of the target constitutes all of the assets of the acquirer immediately after a takeover is not relevant and cited to the Alaska Interstate case to show indirect security exists if the purpose credit lender is put in a preferred position ahead of other creditors with respect to the margin stock. Irell & Manella thinks that Paragraph (h) was broader than other language that purports to limit the interpretation to situations involvinc a shell corporation. Mr. Royal Little, founder of Textron Inc., is concerned with the applicability of this interpretation to entrepreneurial start ups.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  39  V.  Grandfathering Three comments addressed the statement in the  , the notice of the proposed interpretation that if adopted interpretation would not apply to written contracts to extend credit entered into prior to the effective date of the interpretation.  Union Carbide Corp. and Mid-Con Corp.,  both of which are currently subject to leveraged hostile teacher offers, stated that since the proposed action is an interpretation of an existing regulation not a new rule, it can only explain the meaning of existing law and cannot impose new objections or change the current law.  These  comments argue, therefore, that the interpretation, by merely clarifying existing law, would necessarily govern all financing arrangements, regardless of when entered into. Union Carbide further states that if the Board elects to retain the December 31 grandfather date, only financing contracts that are binding, unconditional and complete on that date should be viewed as grandfathered, in order to prevent attempts to initiate and complete highly leveraged takeover attempts prior to the announced effective date. Finally, GAF Corporation, which is making the tender offer for Union Carbide, states that the grandfather provision should be revised to exclude all acquisitions in which the acquiring firm held 5 percent or more of the voting securities of the target company on the effective date of the interpretation.  GAF notes that the recently  enacted New York State anti-takeover law follows this   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  40  approach in grandfatherinq takeover attempts, and would more effectively exclude acquisitions that were underway when the proposal was announced.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  41  ALPHABETICAL LIST OF COMMENTERS  1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  AFL-CIO Allen, John Alliance for Capital Access Anthony, Sarah J. Apache Corporation Assoc. of the Bar of the City New York (Committee on Sec. Reg.) Baird, Chester A. Bass, James K. Berg, William H., Jr. (Mrs.) Bicksler, James L. (Prof. of Finance Rutgers Grad. Sch. of Business) Black, Kenneth N. Business Roundtable California Bankers Association Caronan Partners Champion International Corp. City Capital Corporation Coddington Corporation Cohen Feit & Co. Commodity Futures Trading Comm. Control Data Corporation Department of Justice Dillon, Read & Co., Inc. Domke, Martin R. Drexel Burnham Lambert Economics Laboratory, Inc. Emrie, Debra E. Farley Industries Farley/Northwest Industries, Inc. Federal Trade Commission 1st Farmers & Merchants Nat'l Bank 1st National Bank in Bartlesville Ford, Nancy M. French, M. R., Jr. Fund For Stockowners Rights Gallagher & Beaumont Ginsberg, Barbara W. Goldstein, Simeon H. F. Goodman, Irving Hinds, Dan H., Jr. Hogan & Hartson Hutton (E F) & Company I-Typonex Corporation Irell & Manella Itel Corporation Jacobs, E. Allen (Asst. Prof. of Management, M.I.T.) Jensen, Michael C. (Prof. of Bus., Harvard Bus. Sch.)  (Washington, DC) (Oakland, NJ) (Washington. DC) (Tulsa, OK) (Minneapolis, MN) (New York, NY) (Tulsa, OK) (Verona, PA) (Newark, NJ) (Tulsa, OK) (New York, NY) (San Francisco, CA) (New York, NY) (Stamford, CT) (Los Angeles, CA) (Newport, RI) (New York, NY) (Washington, DC) (Minneapolis, MN) (Washington, DC) (New York, NY) (Carmel Valley, CA) (New York, NY) (St. Paul, MN) (Springfield, MO) (Chicago, IL) (Chicago, IL) (Washington, DC) (Columbia, TN) (Bartlesville, OK) (Nashua, NH) (Kingwood, TX) (Vienna, VA) (Summit, NJ) (Denver, CO) (New York, NY) (Utica, NY) (Houston, TX) (Washington, DC) (New York, NY) (Fort Wayne, IN) (Los Angeles, CA) (Chicago, IL) (Cambridge, MA) (Boston, MA)  42  47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. 77. 78. 79. 80. 81. 82. 83. 84. 85. 86. 87.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Kehl, Marcia A. Kellner, DiLeo & Co. Kocur, John A. Larkin, Terry Latham, Watkins & Hills Lee (Thomas H.) Company Little, Royal Mason, A. J. McChesney, Fred S. (Assoc. Prof. of Law, Emory Univ.) Merrill Lynch & Co., Inc. MESA Petroleum Co. Mayer, Brown & Platt Moran, John L. National Assoc. of Manufacturers Nichols, David K. Perrault, George, Jr. Phillips Petroleum Company Reisner, Carl L. Risk Arbitrage Monitor Poonev, James A. Rosenkranz & Company Rountree, Brooks Securities and Exchange Commission See, Henry W. Seligman (J. & W.) & Co., Inc. Seitz, Thomas G. Shearson Lehman Brothers Skadden, Arps, Slate, Meagher & Flom Salomon Brothers Inc. Stangl, David W. Sullivan & Cromwell Tolone, James J. U. S. House of Representatives U. S. Senate (sub.- Alfonse D'Amato) U. S. Senate (sub.- Slade Gorton) U. S. Senate Committee on Banking, Housing and Urban Affairs University Foods Corporation Unocal Corporation Vorys, Sater, Seymour and Pease Yourshaw, Myron Zenith Insurance Company  (Lakewood, CO) (New York, NY) (Wayzata, MN) (Takoma Park, MD) (Washington, DC) (Boston, MA) (Providence, RI) (Tulsa, OK) (Atlanta, GA) (New York, NY) (Amarillo, TX) (Chicago, IL) (Washington, DC) (Salem, OH) (Bartlesville, OK) (New York, NY) (New York, NY) (Lenexa, KS) (New York, NY) (Collinsville, OK) (Washington, DC) (Wayzata, MN) (New York, NY) (New York, NY) (Washington, DC) (New York, NY) (Tulsa, OK) (Washington, DC) (Chicago, IL) (Washington, DC) (Washington. DC) (Washington, DC) (Washington, DC) (Milwaukee, WI) (Los Angeles, CA) (Washington, DC) (Falls Church, VA) (Encino, CA)  .  43  Type of Commenter  TYPE 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Securities Firm Law Firm Banking Institution Investor Member of Public Government Agency/Official Nonfinancial Corporation Trade Association/Special Interest Group Academic Insurance Industry Money Manager/Investment Advisor Arbitrageurs Labor Union  NUMBER 7 10 2 3 28 8 13 6 4 2 2 1 1
Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102