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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
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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.
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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
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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.
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Federal Reserve Bank of St. Louis
Sincerely,
Douglas H. Ginsburg
Assistant Attorney General
3
BOARD
OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
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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
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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
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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.
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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
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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).
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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
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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,
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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).
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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
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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.
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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.
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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.
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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.
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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,
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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.
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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.
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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
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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.
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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:
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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.
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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.
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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.
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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.
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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
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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).
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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.
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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.
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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.
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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
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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.
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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.
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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).
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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
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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
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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
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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.
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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.
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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
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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
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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
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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.
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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.
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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
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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
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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,
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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;
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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"
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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).
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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
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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.
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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
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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
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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
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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.
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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.
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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
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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.
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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.
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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
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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
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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).
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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
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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.
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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.
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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.
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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.
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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.
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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
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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
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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
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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.
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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.
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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
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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.
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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
@FedFRASER