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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 firstname.lastname@example.org 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