# O

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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

March 11, 2002 **Interpretive Letter #930**

**April 2002**

**12 CFR 1**

Subject: Legal Permissibility of Purchasing Bonds Convertible into
Equity

Dear **\[ \]**:

This letter addresses whether the **\[ *State1* \]** Federal branch of
**\[ \]** ("Bank") legally purchased bonds convertible into equity. The
purchase of the bonds was legally permissible under its Part 1
investment authority if the analysis the branch undertook at the time
supported its conclusion that the bonds were the credit equivalent of
investment grade and marketable, or if at the time it purchased the
bonds, it underwrote them as loans in accordance with the standards of
OCC Banking Circular 181.[^1] In either case, the branch's
examiner-in-charge ("EIC") or the appropriate supervisory office must
find the branch's conclusion or analysis to be sufficient, as documented
by the branch prior to the purchase.

**I. Background**

In September 2000, the Bank and its **\[ *State1* \]** and **\[ *State2*
\]** Federal branches (the "Branches") engaged in three interrelated
transactions: the purchase of bonds convertible into equity, an interest
rate swap, and the sale of a call option on the bonds (collectively, the
"Transactions"). This letter focuses on the bond purchase made by the
**\[ *State1* \]** branch ("Branch").

#### A. The Transactions

The Transactions comprise a callable asset swap. An asset swap is a
synthetic structure that enables an investor to purchase a fixed rate
bond and hedge the interest rate risk by swapping the fixed rate
payments for floating rate payments using an interest rate swap. The
swap converts the asset yield on the bonds from fixed to floating. The
sale of the call option enhances the yield. The asset swap is "callable"
where, as here, the investor sells call options on the bond and the
exercise of the options terminate the swap.

The callable asset swap is described in detail below.

(1) **The Bonds**

**\[ *SPV* \]**, a Special Purpose Vehicle, issued \$550 million in
7-year Eurobonds, convertible after

12 months, at the option of the purchaser, into 8.708 million shares of
**\[ *Co.* \]** stock ("SPV Bonds"). The **\[ *SPV* \]** Bonds are
Eurodollar bonds quoted daily in the market.

The convertible **\[ *SPV* \]** Bonds bear a coupon rate of 4.75%. **\[
\]** ("*Co2*") wholly owns **\[ *SPV*\]** and guarantees the outstanding
principal and accrued interest on the bonds. The Bank and the Branches
purchased \$15 million of **\[ *SPV* \]** Bonds. The **\[*SPV* \]**
Bonds have embedded call options that give **\[ *SPV* \]** the right to
call the bonds. The bonds are not rated.

> **(2) The Interest Rate Swap**

Simultaneously with the purchase of the **\[*SPV* \]** Bonds, the Bank
and its Branches entered into an interest rate swap with **\[ \]**
("*Co3*"). Under the interest rate swap, the Bank and the Branches pay
**\[ *Co3* \]** the fixed rate of 4.75%, the coupon rate of the bonds,
semiannually. In return, **\[ *Co3* \]** agreed to pay the bank a
floating rate of LIBOR[^2] plus a spread of 165 basis points, quarterly.
The swap terminates in 7 years or when the **\[ *SPV* \]** Bonds are
called by **\[ *SPV* \]** , or upon **\[ *Co3* \]** ' exercise of call
options it purchased from the Bank and the Branches (described below).
The Bank and the Branches secured their obligations under the swap by
pledging the **\[ *SPV* \]** Bonds to **\[ *Co3* \]**.

> **(3) The Call Options**

The Bank and the Branches, in connection with the purchase of the
**\[*SPV* \]** Bonds and the interest rate swap, each sold a 7-year call
option on the bonds to **\[*Co3*\]** . **\[*Co3* \]** ' exercise of the
options entitles **\[ *Co3* \]** to purchase all the **\[ *SPV* \]**
Bonds purchased by the Bank and its Branches at a predetermined "strike
price." If the **\[*SPV* \]** Bonds are called, exchanged or redeemed
under the terms of the bonds, **\[*Co3* \]** is deemed to have exercised
its call options and the swap terminates. Under the options' terms, the
Bank and its Branches are prohibited from converting the **\[ *SPV* \]**
Bonds into **\[ *Co.* \]** stock while the Transactions remain
outstanding.

**B. Analysis of the Transactions**

As discussed in Section II of this letter, a national bank may purchase
debt securities as investment securities if the bonds are the credit
equivalent of investment grade and marketable.

The EIC must be satisfied that the information contained in the credit
file demonstrates, at the time of the bond's purchase, appropriate
support for the Branch to treat the bonds as the credit equivalent of
investment grade and marketable.

Here, the Bank and the Branch analyzed the **\[*SPV* \]** Bonds in
connection with the interest rate asset swap and call option, prior to
the purchase of the bonds.[^3] The Bank and the Branch approved the bond
purchase based on **\[ *Co2* \]**'s (the guarantor's) bond
guarantee,[^4] financial strength, and good market reputation and the
convertibility of the **\[ *SPV* \]** Bonds into **\[ *Co.* \]** stock.
Based on their financial review, the Bank and the Branches assigned the
Transactions an internal rating of 3, equivalent to a long term debt
rating of "A," prior to the purchase of the bonds. The bonds were also
quoted daily in the market.

**II. Applicable Law**

**A. Permissible Purchases of Debt Securities**

National banks may purchase "investment securities" for their own
account in an amount that generally may not exceed 10% of the bank's
capital and surplus.[^5] "Investment securities" are "marketable
obligations, evidencing the indebtedness of any person, copartnership,
association, or corporation in the form of bonds, notes and/or
debentures, commonly known as 'investment securities.'" An "investment
security" is "a marketable debt obligation that is not predominantly
speculative in nature."[^6]

To qualify as a Type III security, a bond must be rated investment grade
or, if not rated, the credit equivalent of investment grade, and
marketable.[^7] "Investment grade" means a security that is rated in one
of the four highest rating categories by two or more nationally
recognized statistical rating organizations ("NRSRO") or by one NRSRO if
the security is rated only by one NRSRO.[^8] A security is the credit
equivalent of a security rated investment grade if the bank, after a
sufficient analysis, reaches that determination.[^9] A debt security is
"marketable" if it can be sold with reasonable promptness at a price
that corresponds reasonably to its fair value.[^10]

A national bank may purchase a debt security as an investment security,
even if the security does not qualify as a Type III security, based on
the bank's reliable estimates that the obligor will be able to satisfy
its obligations under that security.[^11] If so, the "reliable
estimates" provision allows a bank to invest in a below investment grade
security or one not determined to be the credit equivalent of investment
grade, if the bank satisfies itself that the securities may be sold with
reasonable promptness at a price that corresponds reasonably to their
fair value.[^12] National banks may purchase securities under the
"reliable estimates" standard in an aggregate amount no greater than 5%
of their capital and surplus.[^13] This limit applies against all
securities in their portfolios acquired on the basis of reliable
estimates, rather than on a per issuer basis.[^14]

Banks purchasing securities permitted under Part 1 must adhere to safe
and sound banking practices and consider, as appropriate, interest rate,
credit, liquidity, price, foreign exchange, transaction, compliance,
strategic, and reputation risk the purchases present.[^15] Any
investments must be appropriate for national banks.[^16]

Alternatively, a national bank may purchase and hold debt securities,
including below investment grade securities, as loans under its general
lending powers, consistent with safety and soundness
considerations.[^17] National banks that purchase debt securities under
their lending authority must comply with the lending limit restrictions
in 12 U.S.C. § 84[^18] and generally may not purchase them in an amount
exceeding 15 percent of the bank's capital and surplus.[^19] Bank
purchasers also must adhere to the prudential standards of BC-181, to
the extent applicable, including the requirement that they perform an
independent credit analysis of the loans to satisfy themselves that the
credits meet their own credit standards.[^20]

**III. Discussion**

**A. Determination of Credit Equivalent of Investment Grade and
Marketable**

To qualify as a Type III security, a bond must be rated investment grade
or, if not rated, the credit equivalent of investment grade and
marketable. The **\[ *SPV* \]** Bonds are not rated. Accordingly, the
Bank and its Branches could only purchase the **\[ *SPV* \]** Bonds as
Type III securities, subject to a 10% limitation, if, at the time of
purchase, they determined the bonds were the credit equivalent of
investment grade and marketable. The Branch's EIC or supervisory office
must find the Branch's conclusion or analysis to be sufficient, as
documented by the Branch at the time of purchase. The subsequent sale of
call options on the bonds by the Bank and the Branches would not affect
a determination that the bonds were marketable.

> **B. The Debt Securities' Conversion Feature is not Prohibited by Part
> 1**

National banks generally may not purchase investment securities that are
convertible into equity at the option of the issuer.[^21] However, a
national bank may acquire convertible debt securities, provided that it
disposes of the securities before the date the conversion option comes
into effect.[^22] A national bank also may purchase debt securities
convertible to equity securities at the bank's option where the bank
does not exercise the conversion feature.[^23]

The Branch would not be prohibited from holding the **\[ *SPV* \]**
Bonds on the basis of the conversion feature because the conversion
feature is in its control. Moreover, because the Branch is prohibited
from converting the bonds into equities under the callable asset swap,
the convertibility of the bonds is not at issue.

**C. The Bonds May be Purchased as Loans**

The Branch may rely on its lending authority to hold the bonds if it
underwrote them as loans at the time of purchase, in accordance with the
standards of BC-181. The Branch's EIC or appropriate supervisory office
must find the Branch's conclusion or analysis under those standards to
be sufficient, as documented by the Branch at the time of purchase.

##### IV. Conclusion

The Branch's purchase of the bonds was legally permissible under its
Part 1 investment authority if the analysis the Branch undertook at the
time supported its conclusion that the bonds were the credit equivalent
of investment grade and marketable, or if at the time it purchased the
bonds, it underwrote them as loans in accordance with the standards of
BC-181. In either case, the Branch's EIC or the appropriate supervisory
office must find the Branch's conclusion or analysis to be sufficient,
as documented by the Branch at the time of purchase. The Branch must
clearly document in its credit files the authority it relies on to make
debt acquisitions at the time of purchase.

I trust the foregoing is responsive to your inquiry. If you have
additional questions, please do not hesitate to contact Tena M.
Alexander, Special Counsel, Securities & Corporate Practices Division at
(202) 874-5210.

Sincerely,

**/s/**

Julie L. Williams

First Senior Deputy Comptroller and Chief Counsel

[^1]: The OCC requires banks to implement "satisfactory controls" over
    loans, including: \[1\] written lending policies and procedures
    governing those transactions; \[2\] an independent analysis of
    credit quality by the purchasing bank; \[3\] agreement by the
    obligor to make full credit information available to the selling
    bank; \[4\] agreement by the selling bank to provide available
    information on the obligor to the purchaser; and \[5\] written
    documentation of recourse arrangements outlining the rights and
    obligations of each party. OCC Banking Circular No. 181 (Rev.)
    (August 2, 1984) ("BC-181").

[^2]: "LIBOR" refers to the London Inter Bank Offered Rate, an interest
    rate that major international banks charge each other for large
    loans of dollars outside of the United States.

[^3]: The bonds are not rated or registered under the federal securities
    laws. The Bank and the Branches considered the Transactions as
    "parts of one single transaction." Although the Bank and the
    Branches did a formal credit analysis on the issuer, they did not
    assign a credit rating on the bonds separate and apart from the
    interest rate swap they entered into with, and the call options they
    sold to, **\[ *Co3* \]**. As a general matter, however, debt
    securities should be assigned their own separate rating.

[^4]: **\[ *Co2* \]** provides an irrevocable, unconditional, and
    unsubordinated guarantee for all amounts payable under the bonds.

[^5]: 12 U.S.C. §  24(Seventh). The investment limitations in 12 C.F.R.
    Part 1 based on the capital stock and surplus of a national bank,
    when applied to a Federal branch or agency, refer to the dollar
    equivalent of the capital stock and surplus of the foreign bank, and
    all the business of the foreign bank and Federal branches is
    aggregated in determining compliance with the limitation. *See* 12
    U.S.C. § 3102(b).

[^6]: 12 C.F.R. § 1.2(e). A security is not predominantly speculative in
    nature if it is rated investment grade. When a security is not
    rated, the security must be the credit equivalent of a security
    rated investment grade. *Id.*

[^7]: *See* 12 C.F.R. §§ 1.2(e) and (f)(2).

[^8]: *See* 12 C.F.R. §§ 1.2(d) and (h).

[^9]: *See* OCC Interpretive Letter No. 912 (July 3, 2001), *reprinted
    in* \[Current Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 81-437.

[^10]: *See* 12 C.F.R. § 1.2(f)(4).

[^11]: *See* 12 C.F.R. § 1.3(i)(1).

[^12]: *Id.*

[^13]: *See* 12 C.F.R. § 1.3(i)(2).

[^14]: *Id.*

[^15]: S*ee* 12 C.F.R. § 1.5(a).

[^16]: *Id.*

[^17]: *See* OCC Interpretive Letter No. 834 (July 8, 1998), *reprinted
    in* \[1998 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 81-288;
    OCC Interpretive Letter No. 833 (July 8, 1998), *reprinted in*
    \[1998 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 81-287; OCC
    Interpretive Letter No. 600 (July 31, 1992), *reprinted in*
    \[1992-1993 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 83,427;
    OCC Interpretive Letter No. 579 (March 24, 1992), *reprinted in*
    \[1991-1992 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 83,349;
    OCC Interpretive Letter No. 182 (March 10, 1981), *reprinted in*
    \[1981-1982 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 85,263.

[^18]: The lending limits in 12 U.S.C. § 84 based on the capital stock
    and surplus of a national bank, when applied to a Federal branch or
    agency, refers to the dollar equivalent of the capital stock and
    surplus of the foreign bank, and all the business of the foreign
    bank and Federal branches is aggregated in determining compliance
    with the limitation. *See* 12 U.S.C. § 3102(b).

[^19]: *See* OCC Interpretive Letter No. 834, *supra*; OCC Interpretive
    Letter No. 833, *supra*; OCC Interpretive Letter No. 579, *supra*.

[^20]: *See* OCC Interpretive Letter No. 663 (June 8, 1995), *reprinted
    in* \[1994 -1995 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶
    83,611; OCC Interpretive Letter No. 579, *supra*.

[^21]: *See* 12 C.F.R. § 1.6.

[^22]: OCC Interpretive Letter No. 359 (April 9, 1986), *reprinted in*
    \[1985-1987 Transfer Binder\] CCH ¶ 85,529; OCC Investment
    Securities Letter No. 55 (August 5, 1991), *reprinted in*
    \[1991-1992 Transfer Binder\] CCH ¶ 83,328.

[^23]: If an option is not exercised, there is no conversion and no
    resultant equity holdings. The OCC similarly has permitted national
    banks to own real estate as principal in various contexts,
    notwithstanding the general prohibition in 12 U.S.C. § 29 against
    banks owning real property. OCC Corporate Decision No. 99-07 (March
    26, 1999) (ownership of real property interests as incidental to
    permitted financing transactions); OCC Conditional Approval Order
    No. 295 and OCC Corporate Decision No. 98-17 (March 23, 1998)
    (same); OCC Interpretive Letter No. 806 (October 17, 1997),
    *reprinted in* \[1997-1998 Transfer Binder\] Fed. Banking L. Rep.
    (CCH) ¶ 81,253 (ownership of real property in a net lease
    transaction that is a loan substitute for Islamic customer); 12
    C.F.R. §1.100(b) (municipal leases). In addition, the OCC has
    permitted national banks to own various types of personal property
    in order to engage in lease-financing activities. *See* 12 C.F.R. §
    23.20; *See also,* Letter from Robert Herman, Deputy Comptroller
    (October 4, 1994) (unpublished) (ownership of an interest in trust
    that purchased hydrocarbon producer payments in connection with
    financing transaction). In all these contexts, the prohibitions
    otherwise applicable to ownership of these assets by a national bank
    as principal are not applicable because owning the asset is deemed
    necessary for the national bank to engage in a permissible banking
    activity or transaction.