Alert June 02, 2009

OCC Issues Interpretive Letter Regarding Purchase of Auction Rate Preferred Securities

The OCC issued Interpretive Letter #1115 (“Letter #1115”), permitting the purchase of auction rate preferred securities (the “Securities”) by a wholly-owned subsidiary (the “Subsidiary”) of a national bank (the “Bank”).  The Securities pay a fixed yield or a specified yield based on a rate or index not under the control of the issuer or the purchaser.  The Securities are perpetual, but may be redeemed at the option of the issuer and contain mandatory redemption provisions that require the issuer to redeem the Securities at par plus accumulated dividends under certain conditions.  The Securities rank senior to the issuer’s common stock and the dividends are cumulative. 

Letter #1115 reiterates that a national bank may purchase for its own account investment securities under such limitations and restrictions as the OCC may prescribe.  The OCC defines an “investment security” as a marketable debt obligation that is not predominantly speculative in nature.  Letter #1115 states that preferred stock is a hybrid instrument that can be structured to resemble either a debt instrument or common stock and notes that OCC precedent recognizes that national banks may purchase preferred stock as an investment security when the characteristics of the instruments are predominately debt-like.  In Letter #1115 the OCC concludes that the Securities qualify as investment securities because they possess characteristics commonly associated with debt instruments: fixed yields, priority over equity shareholders in the case of issuer default, and cumulative dividends. 

In this regard, though the Securities are perpetual, the OCC has recognized that a perpetual preferred stock may qualify as an investment security.  Because the Bank’s holding company (the “Holding Company”) agreed to purchase the Securities after a three year period of time, the OCC determined that the Subsidiary has effectively limited the duration of its investment.  Further, the OCC determined that the Securities’ optional and mandatory redemption provisions potentially limit the Securities’ term.  The Securities have limited rights to vote for at least two directors at a time.  As a condition of the OCC finding that the Securities are a permissible investment security, the Bank agreed to limit the Subsidiary’s exercise of voting rights.  The Bank and the Subsidiary also entered into an agreement with the OCC that requires the Bank and the Subsidiary to enter into an indemnification agreement with the Holding Company whereby the Holding Company will cover certain losses should they occur and the Holding Company will repurchase any of the Securities that become low-quality assets.