**Interpretive Letter #894**

March 10, 2000 **October 2000**

## 12 CFR 3

This is in response to your letter dated **\[ \]**, concerning a
tax-deductible capital instrument developed by Lehman Brothers. The OCC
has determined that the capital instrument described in this letter
would qualify as bank-level Tier 1 capital up to a maximum of 15% of
total Tier 1 capital.

# Background 

**\[ \]** (the "Bank") intends to organize a limited liability company
under Delaware law (the "Subsidiary") and hold all of the common stock
of the Subsidiary. The common stock will represent at least 7% of the
total capitalization of the Subsidiary. The Bank will control the
Subsidiary through its ownership of 100% of the common stock of the
Subsidiary and therefore consolidate the Subsidiary's operations with
its own under generally accepted accounting principles.

The Subsidiary will also issue non-cumulative, perpetual, fixed-rate
Preferred Securities to third party investors. The beneficial interest
in the Subsidiary held by the Preferred Securities investors will be
shown as a minority interest on the Bank's consolidated financial
statements. Dividends on the Preferred Securities will be paid only if
the Subsidiary receives timely payments from its underlying assets. The
Preferred Securities will be redeemable by the Subsidiary only with the
prior approval of the OCC.

The Subsidiary will invest 95% of the proceeds of the Preferred
Securities in a Subordinated Debenture issued by the Bank and 5% of the
proceeds in other assets that meet prescribed credit and maturity
criteria ("Eligible Assets"). The Subordinated Debenture will have a
thirty-year maturity and pay interest at a similar rate and at the same
frequency as dividends payable on the Preferred Securities. The Bank may
defer the interest payments up to five years. After exercising this
deferral option, the Bank may not make any payment on the Subordinated
Debenture without the prior approval of the OCC. Non-payment on the
Subordinated Debenture will not constitute an event of default unless
the OCC has approved a payment. When interest payments resume after a
deferral period, the Subsidiary will pay only the current period
Preferred dividends; the Preferred Security holders are not entitled to
missed dividends. Accrued deferred interest payments on the Subordinated
Debenture will ultimately be repaid to the Bank through dividends on the
common stock of the Subsidiary. Any accrued deferred interest payments
will be invested in Eligible Assets until the common dividend payment
date.[^1] The Subsidiary and the Bank can pay regular common dividends
only if dividends have been declared and paid on the Preferred
Securities.

The Subordinated Debenture will rank junior to the Bank's depositors,
senior and subordinated debt holders and general trade creditors. The
Bank may not redeem the Subordinated Debenture at the end of its 30-year
term without prior approval of the OCC, and no event of default will
occur if the OCC does not grant such approval. The Subordinated
Debenture will not appear on the Bank's consolidated financial
statements.

Upon maturity and repayment of the Subordinated Debenture, the
Subsidiary will invest the resulting proceeds in qualifying Eligible
Assets. These assets are anticipated to include mortgages and
mortgage-backed securities and may be purchased from the Bank on an
arms-length basis. The Preferred Securities investors may elect to
exchange their shares for perpetual, noncumulative preferred stock of
the Bank ("Bank Preferred") if the yield on the Eligible Assets is
insufficient to cover the dividends on the Preferred Securities.

The Preferred Securities will be mandatorily exchanged for Bank
Preferred following the maturity of the Subordinated Debenture if any of
the following events occurs: (1) the Bank becomes undercapitalized under
the prompt corrective action regulations, 12 C.F.R. §6.4(b), (2) the OCC
anticipates that the Bank will become undercapitalized in the near term,
or (3) the Bank undergoes a receivership, conservatorship, winding up or
dissolution.

# Eligibility for Tier 1

Section 2(a)(2) of Appendix A of 12 CFR 3 establishes the components of
Tier 1 capital: (1) common stockholder's equity, (2) noncumulative
perpetual preferred stock and related surplus, and (3) minority
interests in the equity account of consolidated subsidiaries. It is OCC
policy to look to the terms underlying the minority interest to
determine if the requirements for Tier 1 capital are met.

The OCC analyzed the Preferred Securities to determine if they meet the
noncumulative and perpetual requirements of Appendix A. The terms of the
Preferred Securities specify that missed dividend payments will not be
paid to investors, preserving cash at the Bank in the event of financial
stress. The Subsidiary will receive cumulative interest payments from
the Subordinated Debenture, if the Bank has exercised its deferral
option and subsequently received OCC approval to resume interest
payments. However, any payments received by the Subsidiary in excess of
the Preferred dividend for one period will not be paid to the Preferred
investors. The Subsidiary will either return any excess cash to the Bank
via a common dividend or invest in Eligible Assets.

The Bank Preferred must also meet the noncumulative requirement because
of the exchange provision. The Bank Preferred terms specify that the
dividends are noncumulative and payable in a similar manner to dividends
on the Preferred Securities.

To qualify as a Tier 1 capital instrument under Section 2(a)(2) of
Appendix A of 12 CFR 3, a security must be perpetual. This requirement
is intended to ensure that a bank is not forced to redeem the capital
instrument by a specific maturity date or by the investors through the
exercise of an option, particularly during times of financial stress.
The Preferred Securities proposed by the Bank do not have a maturity
date. The terms of the Preferred Securities permit the Bank to call the
securities after five years; however, the Bank may only do so with prior
OCC approval. The Preferred investors do not have the right to put the
Preferred Securities to the Bank. There are no scheduled increases in
the dividend rate or other provisions that might effectively date the
life of the Preferred Securities. Although the initial asset of the
Subsidiary, the Subordinated Debenture, is a dated instrument, the terms
of the Preferred Securities provide for the reinvestment of the proceeds
so that the Preferred Securities remain outstanding beyond the life of
the Subordinated Debenture.

In addition to the criteria of Section 2(a)(2) of Appendix A of 12 CFR
3, the OCC looks at a capital instrument's ability to contribute to a
bank's ability to absorb losses as established in 12 CFR §3.4. The
proceeds of the Preferred Securities are loaned to the Bank and are
available to absorb losses during the life of the Subordinated
Debenture. Two features of the Preferred Securities ensure that they
continue to be available to the Bank to absorb losses after the maturity
of the Subordinated Debenture. First, the mandatory exchange feature of
the Preferred Securities requires the exchange of the Subsidiary
Preferred for Bank Preferred under conditions that indicate financial
difficulties at the Bank. Second, the investors have the ability to
exchange the Preferred Securities for Bank Preferred if the income
generated by the Eligible Assets is insufficient to pay the Preferred
dividends. After such an exchange the investors would have access to
Bank earnings as a source for their dividends and no longer be
restricted to the earnings of the Eligible Assets. This feature provides
a way to address potential investor concerns and may forestall pressure
from the investors for a redemption of the Preferred Securities,
providing another avenue to ensure that the proceeds continue to be
invested in the Bank and are available to absorb any losses incurred by
the Bank.

# Conclusion

The OCC believes that the terms of the Preferred Securities described
above satisfy both the noncumulative and perpetual requirements for Tier
1 capital as defined in Section 2(a)(2) of Appendix A of 12 CFR 3. The
Preferred Securities are therefore eligible to be included in Tier 1
capital; however, they should not exceed 15% of Tier 1 capital. This
limit is consistent with the Basel Committee on Banking Supervision's
statement of October 21, 1998 on innovative Tier 1 capital instruments.

This eligibility applies only to preferred securities that meet the
description in this letter. If you have further questions, please do not
hesitate to contact the resident OCC examiners or the Capital Policy
Division on 202-874-5070.

Sincerely yours,

**-signed-**

Tommy Snow

Director, Capital Policy

[^1]: While the Subordinated Debenture is outstanding, the value of the
    Eligible Assets is limited to 8% of the total value of the
    Subsidiary's assets (15% if the Bank has deferred interest payments
    on the Subordinated Debenture). If the value of the Eligible Assets
    exceeds those limits, the excess will be distributed to the Bank.