TO: Deputy Comptrollers, Department and Division Heads, and All
Examining Personnel.

##### BACKGROUND AND PURPOSE

Highly leveraged debt and equity transactions (HLTs) have become
important sources of business for some commercial banks, as traditional
large corporate lending opportunities become more scarce. Some banks
have earned substantial fees and commissions generated by HLTs, and
capital gains realized from some equity investments in HLTs have been
exceptional.

The OCC supports national bank participation in lending and investment
activities that are legal, creditworthy and consistent with sound
banking principles; such activities include financing related to HLTs.
However, due to the complex nature and level of risk associated with
HLTs, the OCC expects boards of directors and management of national
banks to ensure that their involvement in HLT transactions is governed
by sound policies, careful credit and legal analyses, appropriate
controls, and sound management information systems (MIS).

These are fundamental elements of any sound credit process, but they are
especially important in view of the risk characteristics of many HLTs.
These fundamentals apply not only to banks that originate credits but
also to any national bank that participates in a highly leveraged
transaction. The OCC has already begun focusing closer attention on
these factors in its on-going supervisory activities for national banks.

In early 1988, the OCC began a review of HLT activities at a number of
multinational and regional banks, supplemented by discussions with
investment bankers and other organizations that were active in leveraged
financing. Based on that review, the OCC has developed the following
guidelines for examiners to use during their analysis of a bank\'s HLT
portfolio. The OCC plans soon to issue a summary report of the 1988
project, which will provide additional detailed information and insight
into overall HLT activities.

Note: Because of the complexity of HLTs and legal restrictions on
commercial bank financing activities, various parts of a HLT financing
package may be arranged through the bank, its subsidiaries, or its
parent bank holding company. Accordingly, OCC examiners will work
closely with the Board of Governors of the Federal Reserve System in
assessing a banking organization\'s total participation in and exposure
to HLT activities.

[EXAMINATION GUIDELINES]{.underline}

The following guidelines will assist examiners in assessing the adequacy
of a bank\'s policies, procedures and controls in financing HLTs. The
guidelines are specifically intended to:

-   Determine the extent and types of involvement in HLTs;

-   Assess the adequacy of policy and controls;

-   Assess the adequacy of MIS and other reporting systems;

-   Determine the level of HLT exposure;

-   Determine the nature and extent of mezzanine and bridge financing;

-   Identify HLT concentrations and assess their potential impact upon
    the bank\'s overall condition;

-   Assess the overall condition of the HLT portfolio and determine
    whether HLT exposures represent undue risks;

-   Determine the nature and extent of asset sales, participations and
    other distribution efforts;

-   Assess the impact of HLT exposures on adequacy of the ALLL;

-   Determine the extent of direct and indirect equity investments; and

-   Assess potential conflicts of interest, violations of law, and/or
    unsafe and unsound banking practices.

A. GENERAL POLICY STATEMENT

Examiners should determine whether a bank\'s board has adopted a written
policy statement that clearly defines a highly leveraged transaction
(HLT), as well as the bank\'s overall philosophy and objectives in
financing HLTs. The policy should include:

-   The purpose and use of such financing;

-   Permissible lending and investment activities;

-   Identification of industries suited for such financing;

-   A recognition of the unique characteristics and risks associated
    with high levels of leveraging;

-   A broad-based definition that captures the essence of HLTs and
    includes all credits and investments with similar characteristics
    and levels of risk;

-   In-house limits on exposure for individual credits, specific
    industries, and the aggregate portfolio, to be reviewed at least
    annually by the board;

-   A recognition of the need for independent credit reviews and
    assessments and management information systems (MIS) to monitor
    performance;

-   A recognition of the need for well-defined standards and separate,
    specific guidelines for policy, approval, and review of HLT
    transactions; and

-   An acknowledgment that all HLT-related fees, which may be large and
    take various forms, are to be recognized in accordance with
    Generally Accepted Accounting Principles (GAAP), unless otherwise
    specified in the Call Report instructions. The policy should
    recognize the accounting requirements for fees set forth in FAS 91
    and OCC banking circulars on this subject.

Examiners should review the internal listing of HLTs and ensure that it
captures all financing with similar levels of risk (e.g., LBOs,
recapitalizations, cashouts, etc.). If some credits related to HLTs are
not included, examiners should determine reasons for and significance of
omissions.

B. LENDING POLICY

Examiners should determine whether the board has approved a separate
policy for approving and reporting on HLTs. Such a policy should
supplement policies used in the normal credit process. It should ensure
that all loans identified as HLTs are reviewed and approved through a
separate and distinct process.

The lending policy should include:

-   Control features that specifically recognize the unique nature of
    these credits;

-   MIS type and reporting frequency;

-   Minimum risk ratings and underwriting criteria, such as standards
    for cash flow coverage and other repayment sources;

-   Pricing considerations;

-   Legal review requirements;

-   Requirements for review by asset sales and distribution personnel;

-   Requirements for interest rate protection; and

-   Requirements for, at a minimum, semiannual review of the portfolio
    by line management.

C. PORTFOLIO ANALYSIS AND MIS

Examiners should determine whether a separate, specific MIS and analysis
process has been established as part of the overall management and
control of HLT financing. The process should be sufficiently detailed to
provide management and the board with periodic information on the
overall size, quality and performance of the HLT portfolio.

Examiners should review all MIS and reporting system data on HLTs. The
systems should provide the following information and analysis:

-   Concentration by industry and type of financing, [e.g.]{.underline}
    leveraged buyout, recapitalization, cashout, etc.;

-   Comparisons of current aggregate HIT exposure and significant
    additions to and deletions from previous totals;

-   Information by originator;

-   Risk rating of portfolio and significant changes in risk rating of
    aggregates and individual items;

-   Portfolio aging and performance relative to expectations; and

-   Listing of all refinancing and restructured transactions.

D. DISTRIBUTION AND PARTICIPATIONS

Asset sales, participations, syndication and other means of distribution
are critical elements in the rapid growth of HLT financing. Many banks
have a stated goal of creating assets and redistributing them to limit
their risks by diversifying their portfolios.

The OCC expects both lead and purchasing banks to adopt formal policies
and procedures on sales and distribution of participations in HLT
financing. Management and the board should be familiar with the OCC\'s
guidelines governing asset participations, purchases and sales and
should ensure full compliance with those guidelines (see Banking
Circular 181).

Examiners should review all policies and procedures that relate to
HLT-related asset sales, distribution and syndication efforts. The
policies should include:

-   Credit standards and approval process for counterparty risk;

-   An approved customer list;

-   Sell-down guidelines and disclosure requirements;

-   Repurchase guidelines;

-   MIS and other reporting requirements;

-   Controls on incentive or commission programs; and

-   Accounting guidelines for such items as \"strip\" sales, fees and
    revaluation of assets.

E. INTERNAL REVIEWS

Independent assessments of the HLT portfolio are an important part of an
institution\'s overall control and MIS process. The unique
characteristics and risks of these loans make early detection of
emerging trends and potential problems essential.

Examiners should assess the nature and extent of the bank\'s HLT review
and control process. At a minimum, the process should provide for an
annual review of all HLT credits as a separate portfolio. This process
should supplement the bank\'s normal management review process for the
loan portfolio. The review should include:

-   Assessment of aggregate portfolio, industry and individual
    transaction limits;

-   Testing and reaffirmation of underwriting criteria;

-   Testing for compliance with policy and procedures;

-   Testing of individual risk ratings;

-   Assessment of aggregate risk rating levels and trends;

-   Assessment of significant additions to and deletions from the HLT
    portfolio;

-   Assessment of industry concentrations; and

-   Identification of emerging trends and potential problems.

F. EQUITY INVESTMENTS

Many multinational banking companies have both direct and indirect
equity investments in HLTs. The growth in this area has resulted in part
from the large returns realized by some equity investors in HLTs.
Intense competition for business has led banking companies to provide or
arrange financing for all aspects of a proposed transaction, including
equity positions.

Equity investments have been made by Small Business Investment
Corporations (SBICs\> owned by bank holding companies, and their
affiliates. Indirect investments have been acquired through investment
in specialized funds (LBO funds) whose sole purpose is to provide
financing for HLTs for their own accounts. National banks generally have
not made direct equity investments or investments in LBO funds because
of the restrictions contained on such activities in the Glass Steagall
Act.

Equity investments generally involve higher levels of risk than either
senior or junior debt and should be governed by adequate policies,
procedures, controls and MIS. At a minimum, policies should establish a
approval and review process for such activities.

These policies should include:

-   Aggregate and individual investment limits;

-   Designated booking units;

-   MIS and other reporting requirements;

-   Investment criteria and documentation for investment decisions;

-   Periodic valuation;

-   An internal risk rating system;

-   Independent review and affirmation of values and risk ratings; and

-   Identification of possible conflicts of interest and other legal
    problems created by providing other tiers of debt in the
    transaction.

G. MEZZANINE FINANCING

Mezzanine financing represents those parts of a HLT\'s financing package
that are neither equity nor senior debt. It has been extended through
SBIC subsidiaries of banks or nonbank subsidiaries of bank holding
companies.

Examiners should review policies for mezzanine financing to ensure that
they generally include:

-   Limits for both aggregate volume and individual transactions;

-   Designated booking units;

-   Credit approval and reporting processes;

-   MIS and other reporting requirements;

-   An internal risk rating system and requirements for periodic
    reviews; and

-   Procedures for legal review of HLT transactions.

H. RESERVES

The potential impact of a bank\'s participation in financing HLTs should
be carefully considered when reviewing the adequacy of the allowance for
loan and lease losses (ALLL). The aggregate size and overall condition
of the HLT portfolio should be specifically addressed in any review of
the overall adequacy of the reserve.

Examiners should review the bank\'s methodology for incorporating the
special risks related to HLT financing in its determination of the
adequacy of the ALLL. Management is expected to use an internal risk
rating system to assess its equity and mezzanine financing portfolio and
to determine the need for valuation reserves.

I. LEGAL REVIEWS AND POTENTIAL CONFLICTS OF INTEREST

Examiners should determine whether a bank\'s board of directors and
management have established policies on HLTs to minimize risks posed by
potential legal and conflict-of- interest issues. Policies should
provide for legal review of all bank involvement with HLTs to determine
that they are permissible for banking organizations and to address
potential conflicts of interest.

The legal and regulatory issues raised by leveraged transactions are too
numerous and complex to address fully in this issuance. Several examples
illustrate this point:

-   [Conflicts of Interest]{.underline} \-- Conflicts of interest may
    arise when a banking company is involved in financing a transaction
    and/or takes an equity interest in the transaction. When a banking
    company plays multiple roles in connection with an HLT, the
    interests of different customers, or the interests of the banks and
    its customers, may conflict.

-   [Equitable Subordination]{.underline} \-- If a bank as senior lender
    exercises some measure of management control, a court could rank the
    bank\'s interest on a par with those of junior creditors. A bank may
    be more vulnerable to this risk if its holding company is also
    participating in the mezzanine and/or equity financing of an HLT.

-   [Securities Laws]{.underline} \-- Equity interests and certain debt
    instruments used in HLTs may constitute \"securities\" for purposes
    of federal securities laws. When securities are involved, banks
    should ensure compliance with applicable securities law
    requirements, including disclosure and regulatory requirements.
    Banks should also establish procedures to restrict the internal
    dissemination of material nonpublic information about a HLT to
    persons who are involved in the transaction.

Originating Office:

Multinational Banking Department

Washington, D.C. 20219

\(202\) 874-5170

Dean S. Marriott

Senior Deputy Comptroller

for Bank Supervision Operations