Title: FINAL RULE--Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations--12 CFR Part 615
Issue Date: 10/13/1988
Agency: FCA
Federal Register Cite: 53 FR 40033
___________________________________________________________________________
FARM CREDIT ADMINISTRATION

12 CFR Part 615

Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations


ACTION: Final rule.

SUMMARY: The Farm Credit Administration (FCA) adopts final regulations amending 12 CFR Part 615, Subparts H, I, J, K, L, M, and N relating to the capitalization of Farm Credit System (System) banks and associations. The regulations set forth the statutory requirements for capitalization bylaws, requirements for the issuance and retirement of equities in order to qualify as permanent capital, requirements designed to ensure implementation of cooperative principles, disclosure requirements for the issuance of equities, requirements for the retirement of equities, and, for banks for cooperatives (BCs), a minimum requirement for additions to unallocated surplus. The amendments are made necessary by changes in the capitalization provisions of the Farm Credit Act of 1971 (1971 Act), 12 U.S.C. 2001 et seq., made by the Agricultural Credit Act of 1987 (1987 Act), Pub. L. 100-233. These regulations supersede Capital Directive # 1 and the FCA hereby rescinds that directive on the effective date of this regulation. The effect of the amendments is to give System institutions greater flexibility in determining their capital structures, to provide minimum guidelines for the issuance and retirement of equities that must be met to assure consistency with law and cooperative principles, and to require appropriate disclosure in connection with the issuance of equities. For BCs, the regulations have the effect of requiring a minimum annual addition to unallocated surplus until the unallocated surplus reaches 50 percent of the minimum permanent capital requirement of 7 percent of risk-adjusted assets.

DATES: This regulation shall become effective upon the expiration of 30 days from publication during which either or both houses of Congress is in session. Notice of effective date will be published.

FOR FURTHER INFORMATION CONTACT:

William G. Dunn, Chief, Financial Analysis and Standards Division, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA 22102-5090, (703) 883-4402,
or
Dorothy J. Acosta, Senior Attorney, Office of General Counsel, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA 22102-5090, (703) 883-4020, TDD (703) 883-4444.

SUPPLEMENTARY INFORMATION: On September 2, 1988, the FCA published for comment (53 FR 34109) proposed regulations amending 12 CFR Part 615, Subparts I, J, K, L, M, and N relating to the capitalization of System banks and associations. The regulations set forth the statutory requirements for capitalization bylaws, requirements for the issuance and retirement of equities in order to qualify as permanent capital, requirements designed to ensure implementation of cooperative principles, disclosure requirements for the issuance of equities, requirements for the retirement of equities, and, for banks for cooperatives (BC) a requirement for minimum annual additions to unallocated surplus. The amendments were proposed in response to changes in the capitalization provisions of the Farm Credit Act of 1971 (1971 Act), 12 U.S.C. 2001 et seq., made by the Agricultural Credit Act of 1987 (1987 Act), Pub. L. 100-233, and are referred to as capital adequacy related regulations because of their relationship to the capital adequacy regulations adopted by the FCA on September 28, 1988 and published on October 6, 1988 (53 FR 39229). The capital adequacy regulation requires System institutions, by 1993, to maintain permanent capital at no less than 7 percent of risk-adjusted assets. The capital adequacy regulation was first published as a proposed regulation on May 12, 1988 (53 FR 16948) after considering comments received in response to an advance notice of proposed rulemaking (53 FR 4642, February 17, 1988). The proposed capital adequacy regulation was the subject of a public hearing on June 9, 1988, and a resolicitation of comments on August 10, 1988 (53 FR 30071). The comment period on the proposed capital adequacy related regulations closed on September 16, 1988.

Twenty-six comment letters were received representing the views of 9 Farm Credit Banks (FCB), 6 banks for cooperative (BC), 10 production credit associations (PCA), 10 Federal land bank associations (FLBA) and 1 Federal intermediate credit bank (FICB) as well as the Central Bank for Cooperatives (CBC), the Farm Credit Corporation of America (FCCA), the Federal Farm Credit Banks Funding Corporation (Funding Corporation), the Shareholder Advisory Council for the FLBA and PCA of Omaha, and the St. Paul District Federation for the FLBAs and PCAs in the St. Paul District.

The respondents' comments and the FCA's response are summarized below.

A. General

The FCA was requested by one respondent to extend the comment period and by another to publish as a proposed rule whatever regulation the FCA determines is appropriate after considering the comments. The respondent argued that the brevity of the comment period, in light of the complexity of the issues and the significance of the implications of the regulations, made an opportunity for additional comment advisable. The FCA did not accept these recommendations because the FCA believes that institutions that are attempting to implement the new capitalization provisions and the restructuring provisions of the 1987 Act need greater certainty about the FCA's regulatory stance than either of the respondents' proposals would provide. Therefore, the FCA adopts the proposed regulation as a final regulation with the modifications discussed below, effective after the expiration of 30 days from publication during which either or both houses of Congress is in session.

Legal Authority

A number of the respondents challenged the FCA's authority to regulate in the various areas addressed by the regulation on the theory that the 1987 Act left such matters to System institutions and their shareholders in the capitalization bylaws. Some respondents argued that such regulations amounted to bylaw approvals and pointed out that Congress has expressly prohibited such approval of bylaws, either directly or indirectly, in section 5.17(b) of the 1971 Act, as amended. Since these arguments were used to support a number of specific objections to the regulation, the FCA believes it important as a preliminary matter to respond to these arguments generally.

The FCA recognizes that it is without authority to approve an institution's bylaws, directly or indirectly, and has no interest in doing so. However, many respondents appear to believe that institutions have unfettered discretion in any matter that is addressed in their bylaws so long as the bylaws do not contravene the statute. The FCA disagrees. Notwithstanding section 5.17(b) of the 1971 Act, the FCA continues to have, after the 1987 Act, general rulemaking authority, and the 1971 Act, as amended, specifically refers to FCA regulation in areas that must necessarily be reflected in the bylaws. The FCA does not believe that Congress intended to foreclose the FCA from regulating in any area in which it has a legitimate regulatory interest, and certainly not in areas in which the statute specifically refers to FCA regulation, merely because such matters are of necessity reflected in the institution's bylaws. If the argument made by respondents in this regard is carried to its logical extension, institutions would be able to avoid regulation altogether by including all matters subject to regulation in their bylaws. If Congress had intended to neutralize the regulatory authority of the FCA, it would not have included the many specific references to FCA regulations in new provisions of the statute relating to the issuance and retirement of equities. For example, sections 1.6, 2.3,. 2.13, and 3.25, provide that the institutions shall:

* * * provide, through bylaws and subject to Farm Credit Administration regulations, for the capitalization and the manner in which [the institution's] stock shall be issued, held, transferred, and retired and [its] earnings distributed.

12 U.S.C. 2014, 2074, 2094 and 2145. Sections 3.3, 3.4, 3.11, and 3.25 of the 1971 Act, which set forth capitalization provisions for BCs, also make specific reference to FCA regulations. In addition, all of the corporate powers of System institutions are granted subject to the regulation of the FCA, and the FCA is granted general rulemaking authority for regulations that are necessary and appropriate to carry out the purposes of the 1971 Act.

The FCA is aware that its regulations must be consistent with the 1971 Act and is further aware that, to the extent there is any inconsistency between section 4.3A and other provisions of the 1971 Act, section 4.3A controls. However, the FCA does not believe its proposed regulations are inconsistent with the statute or that the absence of a reference to FCA regulations in section 4.3A and the reference to FCA regulation in sections 1.4, 2.3, 2.13, 3.11, and 3.25 is such an inconsistency. Significant changes were made in the capitalization provisions of Titles I and II of the 1971 Act by the 1987 Act, but the FCA's authority to regulate the institutions' capitalization and the issuance and retirement of stock and distribution of earnings continues to be referenced. In light of the attention given to these provisions, Congress cannot be deemed to have inadvertently failed to conform inconsistent language or to have deliberately created an inconsistency in the 1987 Act. In addition, a similar reference is made to FCA regulation in this area in section 410 of the 1987 Act, which requires the rights and privileges of shareholders, including voting power, redemption rights, preferences on liquidation, and the right to dividends to be determined by the plan of merger and consistent with section 4.3A of the 1971 Act and regulations issued by the FCA. Moreover, the Agricultural Credit Technical Corrections Act, Pub. L. 100-399 (Technical Corrections Act), which was enacted on August 17, 1988, amended section 3.25 of the 1971 Act to add a reference to FCA regulation of capitalization and the issuance and retirement of equities and the distribution of earnings in the National Bank for Cooperatives.

While the FCA agrees that it is inappropriate to prescribe the content of bylaws, the FCA believes that there is ample authority to regulate the matters addressed by the proposed regulation. The proposed regulation may have been interpreted as an attempt to prescribe bylaws because the regulatory requirements for implementing cooperative principles in the issuance and retirement of equities and distribution of earnings and the requirements for qualification as permanent capital, all legitimate subjects of regulation, were cast in the context of the adoption of new capitalization bylaws. The FCA has removed references to the bylaws in the sections of the final regulation dealing with the issuance and retirement of equities. The regulatory requirements concerning these matters are, however, substantially the same as the proposed regulation, except as they have been modified in response to more substantive comments. The FCA does not believe that this contravenes the prohibition on direct or indirect approval of bylaws. The FCA has been careful to confine its regulations to matters in which it believes there is a legitimate and important regulatory interest and to leave institutions maximum flexibility in implementing such requirements in their bylaws.

Capital Directive

In the preamble to the proposed regulation, the FCA announced its intention to rescind Capital Directive #1 (Directive) when both the capital adequacy regulations and the capital adequacy related regulations have become effective. A number of respondents urged the FCA to rescind the Directive effective October 6, 1988, in order to allow institutions necessary flexibility in adopting new capitalization bylaws. On September 14, 1988, the FCA issued a bookletter addressing certain required approvals under the Directive that the FCA believed might be needed if the Directive were in effect when institutions adopt new capitalization bylaws. The FCA believes the letter will adequately address the concerns of these respondents and declines to rescind the Directive until capital adequacy regulations and capital adequacy related regulations take effect. These regulations supersede the Directive and the FCA hereby rescinds it on the effective date of this regulation.

Reassignment of Association

Three respondents stated that the FCA has the responsibility to require the orderly disposition of capital to give effect to the purposes of section 433 of the 1987 Act (which relates to the reassignment of associations to adjoining districts) and urged the FCA to require in these regulations that the bank of current affiliation may not, for any reason, withhold the transfer of association capital to the adjoining bank. Without commenting on the merits of the respondents' arguments, the FCA has concluded that, given the limited time within which section 433 transfers can be initiated and the statutorily mandated involvement of the Farm Credit System Assistance Board, decisions regarding transfers of capital between districts are best left to a case-by-case evaluation of the effects of such transfers on the parties involved. Consequently, the final rule does not address this issue.

B. Subpart I -- Issuance of Equities

Section 615.5220 -- Capitalization Bylaws

In the proposed regulation, the statutory requirements for the new capitalization bylaws were set forth in this section in a manner that clarified how the FCA will interpret these requirements for the purpose of determining whether bylaws adopted by institutions meet the statutory requirements. In addition to the general objection to regulations addressing bylaws noted above, there were a number of specific comments on this section.

A number of respondents objected to the requirement to set forth the number of shares of each class of stock to be issued (except stock issued as a condition of obtaining a loan) because they believed it would be impractical to secure shareholder approval every time the institution needed to increase its capital. Some noted the lack of specific mention of such a requirement in the statute and asserted that such a requirement is unnecessary in view of the right to vote on any issuance that would create a preference. One respondent suggested that shareholders are adequately protected by the required vote on preferred stock. Several recommended that the number of shares to be issued be left to the discretion of the board of directors. Another respondent recommended that if the requirement were retained in the final regulation, the number of shares of stock resulting from the conversion of voting stock to nonvoting stock should be permitted to be authorized in unlimited quantities.

While there is no specific statutory reference to the number of shares of stock to be issued, the FCA believes that such a requirement is implicit in the requirement that the bylaws must enable the institution to meet its minimum permanent capital requirements and the requirement for shareholder approval of bylaws. In addition, the FCA believes that such a requirement is necessary to give substance to the voice Congress gave shareholders by requiring shareholder approval of such bylaws.

The FCA recognized that it would be impractical to set forth in the bylaws the number of shares of the class of stock to be issued to borrowers to satisfy the minimum stock purchase require and excepted this class of stock from the requirement of the proposed regulation. Also the FCA agrees that nonvoting stock resulting from a conversion of voting stock after the loan is paid off should be authorized in unlimited amounts because of the institution's inability to estimate the number of shares of such stock that would need to be authorized. The requirement of the proposed regulation was intended to apply primarily to stock issued to non-borrowers and to preferred stock. Such a requirement is important to protect shareholders from preferences and from dilution of ownership by other issuances. While dilution of ownership is not as serious a problem when the additional stock issued is nonvoting, it continues to be an issue, even for nonvoting common, when all shareholders are allowed to vote on the issuance of preferred stock. In addition, neither the 1971 Act nor the final regulation requires that stock be retired at book value not to exceed par, and institutions could conceivably opt for a capital structure that would allow stock to be retired at book value. In that event, it would be even more important to have shareholders vote to authorize the issuance of additional stock, as the book value of the stock could affect its trading value.

Institutions that are concerned about the need to hold shareholder meetings too often can request shareholders to authorize more stock than they presently intend to issue. Shareholder meetings are held annually in any event. It should be noted that most corporations are required to obtain shareholder authorization to issue stock, and some, such as national banks, are also required to obtain regulatory approval. As noted above, the final regulation retains the requirement that the number of shares authorized to be issued be specified in the bylaws, but excepts from this requirement voting stock and participation certificates issued in connection with a loan and nonvoting stock that results from the conversion of voting stock into nonvoting stock after the loan is repaid.
A number of respondents also objected to the requirement to state in specific terms in the bylaws the institution's stock purchase requirement. Rather, these respondents understand the statute to require merely a statement that there is such a requirement, to be determined by the institution's board, which shall be at least the statutory minimum. Some respondents believe that the requirement of the proposed regulation is impractical, since the level of stock needed may change as economic and business circumstances change and that boards of directors should have more flexibility in determining the stock purchase requirement. One respondent argued that Congress did not intend to burden shareholders by requiring a shareholder vote on the stock purchase requirement each time it changes and noted that the borrower is protected by disclosure of the requirement and the option of borrowing elsewhere if the requirement is unacceptable.

The FCA reads the statute to require shareholder approval of the stock purchase requirement. The FCA was not persuaded by the argument that shareholders should not be burdened with voting on changes in stock purchase requirements and that they are adequately protected by disclosure of the stock purchase requirement. This would not permit a shareholder any vote on the requirement except a "yes" vote, since the price of "no" vote is not to become a borrower. Prior to the 1987 Act, shareholders had no opportunity at all to vote on the bylaws. Now shareholders are specifically authorized to vote only on the capitalization portion of the bylaws. The FCA assumes that Congress gave shareholders the right to vote on the capitalization bylaws because of the significance of these provisions to borrowers. There can be few issues related to the capitalization bylaws which are as significant to a borrower as the stock purchase requirement, and it seems clear from its inclusion among the bylaw requirements enumerated in the statute that Congress intended shareholders to have a voice in establishing it. Furthermore, in the Technical Corrections Act, Congress amended section 4.3A(c)(1)(H), which states that the bylaws "do not need to provide for maximum and minimum standards of borrower stock ownership based on a percentage of the loan of the borrower," by adding the phrase "except as otherwise provided in this section." The stated purpose of this amendment was to correct the inconsistency between this provision and section 4.3A(c)(1)(E)(i), which requires that the bylaws state the stock purchase requirement. (See 134 Cong. Rec. S 10804, August 3, 1988.) This action by Congress would appear to evidence an intent for shareholders to have a voice in establishing the stock purchase requirement.

The FCA does not believe that changes in the stock purchase requirement are likely to be so frequent as to make obtaining shareholder approval burdensome. If the capital planning function is properly conducted, it should be possible to estimate with a reasonable degree of accuracy the required capital level for at least the one-year period between shareholder meetings. Nevertheless, if shareholders wish to authorize the board of directors to establish the requirement within a certain range, the final regulation would permit it. The requirement has been modified in the final regulation to allow the requirement to be expressed as a range within which the institution's board may change the requirement from time to time as circumstances warrant.

Some respondents, especially BCs, objected to specifying a maximum in the bylaws. The FCA believes that the statute contemplates shareholders having some voice in establishing stock purchase requirements and that shareholders should not be given a choice between unfettered board discretion and no bylaws at all. However, the FCA has concluded that the statutory requirement needs to be interpreted in the context of the long established business practices for capitalizing the BCs, so as not to disrupt existing and long-standing relationships of the BCs with their borrowers. BCs typically require a minimum initial capital requirement with additional equity investments over a period of years until a target level of equity investment is reached. In the BC context, the FCA interprets the statutory requirement to be to allow shareholders to approve a target range for equity investment in the bank and to authorize the bank's board to implement the target levels in the capitalization plan. Section 615.5220 of the final regulation has been expanded to add a new paragraph (e) setting forth the requirement for BCs, which also takes into account the fact that some portion of the BC's business is not conducted on a patronage basis. Paragraphs (e), (f), (g), and (h) of the proposed regulation have been redesignated as (f), (g), (h), and (i), respectively, in the final rule.

One respondent noted that paragraph (d) of 615.5220 could be read to require a borrower whose loan is repaid, but whose stock cannot be retired because the institution does not meet its capital standards, to purchase additional stock to obtain a new loan. Such a result was not intended and the phrase "from the institution" has been deleted in paragraph (d) in the final regulation, to avoid the implication that causes the respondent's concern. However, paragraph (b) 615.5240 in the final regulation, which was designated as paragraph (c) in the proposed regulation, requires borrowers to purchase their qualifying stock from the institution rather than from other shareholders when minimum permanent capital standards are not met (See discussion of this issue later in this document.)

As several respondents pointed out, the Technical Corrections Act has clarified an issue under section 4.3A(c)(1)(G) regarding whether the 1987 Act required conversion of some portion of participation certificates and nonvoting stock into voting stock. Conforming changes have been made in 615.5220(f) in the final regulation to clarify that only voting stock is required to be so converted by inserting the word "voting" before "stock protected under section 4.9A of the 1971 Act" and inserting the words "new voting" before "stock issued under a capitalization bylaws adopted pursuant to section 4.3A."

One respondent expressed concern that many borrowers and System leaders may be unaware that the conversion of protected stock into stock issued under the new bylaws is mandatory and that the stock exchanged for new voting stock loses its protection in the exchange. Indeed, the respondent's concern proved to be well founded, as another respondent asserted that such stock does not lose its protection in the exchange, arguing that section 4.3A(g) of the 1971 Act makes it clear that if anything in section 4.3A conflicts with the protected stock provisions of section 4.9A, section 4.9A controls. The respondent argued that the Congressional intent of section 4.3A(c)(1)(G) was that no shareholder eligible to vote previously under a statutory right should somehow be disenfranchised through adoption of bylaws by shareholders.

The FCA confirms that the exchange is mandatory and not at the option of the holder, but notes that the amount required to be exchanged must be approved by shareholders. The FCA disagrees with the respondent who argues that such stock retains its protected status in the exchange by virtue of section 4.3A(g) of the 1971 Act. Section 4.3A(g) provides:

To the extent that any provision of this section is inconsistent with any other provision of this 1971 Act (other than section 4.9A), the provision of this section shall control.

The respondent reads more into this section than is there. The effect of this section is not to make section 4.9A paramount, as the respondent asserts. Rather, the effect is merely to require a construction that gives effect to both sections. Since the stock to be issued under the new bylaws is clearly not protected, the only way to give effect to section 4.3A is to read section 4.3A(c)(1)(G) to mean that at least some portion of protected stock is exchanged for new at-risk stock. The FCA understands the interplay of sections 4.3A and 4.9A in the following manner: Congress conferred a benefit on existing shareholders by protecting outstanding stock, but required them to exchange a portion of that stock (the amount to be determined by the institutions and their shareholders in the capitalization bylaws) for stock that is not protected. The FCA does not regard the exchange as depriving the shareholder of rights granted by Congress. Rather, the FCA believes that Congress gave shareholders a benefit of indeterminate size (because of the mandatory conversion feature of section 4.3A) and allowed shareholders, by a majority vote, to determine the size of the benefit. Inasmuch as these provisions were simultaneously adopted, the FCA does not believe that the respondent's concern that the dissenting shareholders may have a cause of action against the institution is warranted or that any constitutional questions are raised. The FCA does not agree that the provision was merely intended to ensure that no one is disenfranchised. If that were the case it would not have been necessary to make the provision mandatory. Rather, the FCA believes the provision was to ensure that the persons who are entitled to vote have at least a minimal stake in the operation of the institution through the ownership of at-risk stock.

Also, the FCA understands the statute to mean that as a result of this exchange, the borrower loses any right he or she previously had to the retirement of the stock upon repayment of the loan, since stock issued under the new capitalization bylaws must be retireable solely at the discretion of the board. This does not mean that the stock cannot be retired upon repayment of the loan if the institution meets its minimum permanent capital requirements. It does mean that the stock the shareholder receives in exchange is permanent capital subject to the statutory prohibition against the retirement of stock or the distribution of earnings in cash if the institution does not meet its minimum capital requirements (including interim standards, but not including forbearance criteria). Institutions should assure that appropriate disclosures of this effect is made to shareholders at the time the capitalization bylaws are proposed for adoption.

One respondent urged that certain terms of the issuance of equities (i.e. dividend rate) be left to the discretion of the board of directors, based on the advice of investment bankers to allow institutions to successfully sell preferred stock to investors. Since pricing terms must be set at the time an issue is marketed, the requirement for shareholder approval of such terms was thought to restrict the ability to market preferred stock. The FCA believes that the requirement need not have that effect if shareholders are asked to approve such terms within a specified range. The pricing potential of a particular issue can usually be described within a relatively narrow range. The dividend rate goes to the heart of the reason shareholders are asked to approve such issuances and the FCA does not believe that shareholders should be asked to give directors unfettered discretion.

Many respondents requested the FCA to confirm their interpretation that the term "minimum permanent capital adequacy standards established by the FCA under Subpart H," as used in paragraph (f) or the proposed regulation (redesignated as paragraph (g) in the final regulation), as well as in 615.5240(c), 615.5270(b) and 615.5330 includes the forbearance criteria as well as the interim standards. Some respondents asserted that many System institutions cannot operate as competitive, viable institutions if they are unable to retire stock until they meet the final capital requirements that must be met by the end of the five-year phase-in period.

The final regulation clarifies that the phrase "minimum permanent capital adequacy standards established by the FCA under Subpart H" includes interim standards in each of the sections in which it appears except 615.5330, where it refers to the 7 percent standard required by 1993. As stated in the resolicitation of comments on the capital adequacy regulation and in the preamble to the final capital adequacy regulations, forbearance criteria are not interim standards. Meeting the forbearance criteria merely protects the institution from enforcement action for failure to meet its interim permanent capital standards. If the FCA were to consider forbearance criteria as minimum permanent capital standards, it would not be possible for the FCA to extend forbearance beyond 1993. While the FCA cannot confirm the interpretation many institutions wish to give to the term "minimum capital standards" to include forbearance criteria, the FCA notes that the statute allows the payment of patronage in equities that qualify as permanent capital at the issuing institution provided the portion paid in cash is limited to that amount necessary to qualify the refund under Federal tax law as a deductible patronage refund.

On FCB asserted that stock issued to PACs in connection with the mandatory merger of the FLB and the FICB is not protected and not permanent capital and objected to the requirement of paragraph (f) of 615.4230 in the proposed regulation (redesignated as paragraph (g) in the final regulation) that states that all stock except protected stock must be retireable at the discretion of the institution's board. The FCA knows of no reason why stock issued to PCAs in connection with the mandatory merger would not qualify as permanent capital. However, the provisions of 615.5220 are prospective only and reflect the FCA's judgment that after October 5, 1988, only stock that may be retired at the discretion of the board may be issued. (See further discussion later in this document.)

One respondent suggested that the FCA clarify that the requirements of 615.5220(g) of the proposed regulation (redesignated as paragraph (h) in the final regulation) apply only to the bylaws of Farm Credit Banks. The FCA confirms that this is the correct interpretation and has reworded the section in the final regulation to make clear that the manner of allocation and equalization of the capitalization requirements of the FCB need only be addressed in the bylaws of the FCB.

Section 615.5230 -- Implementation of Cooperative Principles.

The proposed regulation required institutions to reflect cooperative principles of one-person-one-vote and equitable treatment of patrons of the cooperative in their bylaws and stated minimum regulatory requirements designed to assure that System banks and associations continue to operate cooperatively. Some respondents challenged the FCA's legal authority to regulate in many of these areas.

Voting Rights

Provisions setting minimum standards for cooperative voting rights that must be accorded shareholders were alleged to be without statutory basis and in conflict with sections 1.4, 1.6, 2.1, 2.3, 2.11, and 2.13 of the 1971 Act, which, the respondents asserted, specifically provide for the institutions to consider alternatives other than those specified in the regulation. Specific objections were raised to weighting the votes of association/shareholders in proportion to the number of members of the association. One respondent cited the repeal of the specific provisions for electing the district boards (which were identical to those of the proposed regulation for bank shareholders) and asserted that Congress, where it has intended to establish the number of votes which an association/shareholder would have, has specifically stated the statutory requirement, such as in sections 7.0 and 7.6 of the 1971 Act. This respondent concluded, from the failure of Congress to specifically provide for weighted voting in the sections relating to the election of directors, that Congress intended institutions to have unfettered discretion in determining how this should be done.

One respondent argued that weighted proportional vote may deprive small associations of any voice in the affairs of its bank if the district is dominated by a large districtwide association and would be contrary to the 1985 amendments to section 5.17(a)(2), 12 U.S.C. 2252(a)(2). Another respondent urged that more flexibility be allowed in the weighting of association votes, perhaps on the basis of the number of voting shares outstanding or some combination of the number of shares and the number of shareholders, as the 1987 Act permitted banks for cooperatives in the vote for consolidation. The effect of such a combination would be to give some associations additional weight based on the size of their loan portfolios and would give associations serving larger borrowers more weight than an association serving smaller borrowers.

The FCA finds no specific provision in the sections of the 1971 Act referred to by respondents for alternatives other than those required by the proposed regulation. Sections 1.4, 2.1 and 2.11 merely refer to the institution's power to establish the number, term and qualifications of such directors and the manner in which directors are to be elected in their bylaws. The FCA does not read the reference to the manner in which they are elected to refer to voting rights of shareholders, but to refer to election procedures. The FCA regards voting rights as a term and condition and a defining characteristic of the equity, which is determined at issuance and is more properly a matter that comes within sections 1.6, 2.3, and 2.13 of the 1971 Act, all of which indicate that the capitalization of the institution and the issuance and retirement of equities are subject to FCA regulation. The FCA interprets the repeal of the provisions relating to the district board to be more related to the need to conform the statute to the restructuring of the System than to a desire to allow institutions complete flexibility to accord shareholders voting rights that do not reflect cooperative principles. The effect of the deletion of the specific capitalization provisions and specific provisions governing voting rights of association shareholders is to give the FCA broader discretion in regulating the issuance and retirement of equities.

The FCA relies on its general rulemaking authority to discharge what it regards as its regulatory obligation to ensure that institutions are operated as cooperatives and that the owners of System institutions are accorded their full voting rights and are fairly treated. In keeping with the strong message sent by Congress in the 1987 Act that local control and management are to be encouraged, the proposed regulation required that the one-person-one-vote principle be applied at the bank level on a "look-through" basis by weighting the vote of each association shareholder in proportion to the number of its voting shareholders. This weighting is consistent with the weighting prescribed by Congress in the 1971 Act prior to its amendment in 1987 and has been System practice in the election of district boards for many years. The FCA continues to believe that weighting votes in proportion to the number of shareholders is the fairest method and gives the fullest expression to cooperative principles and the emphasis on local control and management that is evident in the 1987 Act. The fact that the proposed regulation is consistent with deleted district board election provisions and new merger provisions mandating weighted voting is evidence that the FCA's interpretation of the appropriate implementation of cooperative voting principles is consistent with the judgment of the Congress on this issue.

That weighting the votes in this manner will give large associations more influence than small ones in unavoidable and not altogether undesirable, since large associations represent more borrowers. To allow each association one vote in the affairs of the bank regardless of the number of borrowers it represents would allow smaller associations to wield disproportionate influence over the affairs of the bank and would not accurately and fairly reflect local control of System institutions by their ultimate owners, the borrowers. The FCA believes that allowing each association to have only one vote would be more unfair. This does not mean that small associations should or will be the subject of unfair discrimination. Directors owe fiduciary duties to all shareholders and can be held accountable for the faithful performance of those duties by those shareholders. To respond to the concern that smaller associations would be disadvantaged, the final regulation requires the bank to allow cumulative voting unless each association agrees otherwise, which will allow small associations a greater opportunity to place a director on the board. The final regulation retains the requirement for weighted voting in proportion to the number of shareholders.

The FCA regards equity weighted voting in the FCB (except in the issuance of preferred stock) as inconsistent with the 1971 Act, as amended. Although Congress required the BCs to use a combination of one-person-one-vote and equity weighted voting for BCs, for banks other than BCs, Congress required the votes of association shareholders to be weighted in proportion to the number of association shareholders in votes on mergers between banks within a district (section 7.0), on mergers of similar banks (section 7.12) and on transfers of lending authority (section 7.6). The only places in the statute referring to a required vote in which such weighting is not expressly required are those sections that apply to both banks and associations, where language appropriate to voting on association matters is used. The FCA believes it necessary and appropriate to interpret such language in the bank context consistently with other references to voting rights of associations in the statute. To interpret the language literally would lead to absurd results. For example, the language of section 7.9(b)(4), if read literally, would mean that a merger of banks approved by weighted proportional voting could be undone by a one-association-one-vote ballot upon reconsideration.

One respondent requested clarification of the voting scheme for the initial vote on the capitalization bylaws of the bank, citing statutory language of section 4.3A(c) of the 1971 Act, as amended, which requires approval by a majority of the shareholders of each institution present and voting. The respondent suggested that in such a vote each association should have one vote. The language of 4.3A relating to shareholder approval of the adoption of capitalization bylaws is identical to that of section 7.9(b)(4) and references votes by associations as well as banks. As noted above, the FCA believes that this language in the bank context should be interpreted consistently with the many other express voting provisions in the 1971 Act to require a vote weighted in proportion to the number of shareholders, to avoid absurd results Adopting the interpretation suggested by the respondent would operate unfairly in districts in which all but one or two associations have merged into a districtwide association, allowing a single stand-alone association to wield an influence disproportionate to the number of persons served by the association. The FCA does not believe that such an interpretation would give effect to the Congressional purpose of promoting local control of System institutions. The FCA believes that since the capitalization bylaws affect the economic interests of the shareholders in a most direct manner, fundamental fairness requires that the votes of the associations be weighted in accordance with the number of shareholders served by the association.

Several respondents objected to the requirement that each voting shareholder be allowed to vote in the election of each director. Some viewed this requirement as in conflict with the flexibility provided by the 1971 Act, as amended, and without statutory authority. A number of institutions argued that the regional election of directors is important in associations covering large geographic areas, since it may be difficult for borrowers in one region to be fully informed and make intelligent judgments about candidates residing in far distant areas. Regional voting is well established in associations, some of which to continue to elect directors on a regional basis. These respondents believe regional voting is in accordance with the 1971 Act, amended, and expected by the associations and their shareholders. In one district regional voting is thought to be an important component of merger plans. Several respondents suggested that an exception be made for districtwide associations.

The requirement that each shareholder be allowed to vote in the election of each director was designed to assure that full voting rights are accorded to each shareholder. While the FCA views broad geographical representation on the board of directors as a desirable goal, just as representation of various types of agriculture is a desirable goal, these goals should not be achieved at the cost of disenfranchising shareholders by depriving them of the opportunity to vote for all director positions. Directors owe fiduciary duties to all of the shareholders and shareholders who are not able to elect them are handicapped in holding them accountable. Also, a shareholder who can only vote for one director out of several and is not allowed to vote on the others may be disadvantaged in influencing the management of the institution if he or she resides in a region that has more borrowers than other regions. That is to say, the votes of shareholders that reside in a region with many borrowers have less weight than those of shareholders that reside in regions that have fewer borrowers.

While geographic representation is a desirable goal, the FCA believes the goals may be achieved by designating director positions geographically, that is, requiring that a particular position be filled by a person from a particular geographic region, but allowing all shareholders to vote in the election of each director. Such a method, when coupled with cumulative voting, which would allow each voter to cumulate his or her votes and distribute them among the candidates for director as the voter sees fit, would accord each shareholder full voting strength and allow for geographic representation as well. Accordingly, the final rule continues to require that each association shareholder be accorded the right to vote for each director, but also requires cumulative voting in the election of directors unless the capitalization bylaws provide otherwise. However, in view of the fact that regional voting was allowed in districtwide associations resulting from the merger of many associations into one, the final rule grandfathers until January 1, 1993, existing regional voting arrangements to allow for a smooth transition.

Equitable Treatment

Some respondents objected to the requirement that the issuance of preferred stock be authorized by a majority of the shares of each class of stock affected by the preference, voting as a class, rather than by a majority of shareholders as in conflict with the Flexibility provided by the 1971 Act. Because the issuance of stock that is preferred as to dividends or upon liquidation has a direct impact on the value of the common shareholder's investment in the institution, and the impact is magnified by the number of shares of stock owned, the FCA continues to believe that shareholders should be entitled to vote on a per share basis on these issues and that the approval of all affected classes should be obtained. The FCA notes that System institutions have historically been required to authorize preferred stock in this manner. The 1971 Act subjects the issuance of equities to FCA regulation and the FCA believes that such a requirement is necessary and appropriate to ensure fair treatment of borrower/shareholders.

Several respondents asked that this requirement be modified to allow existing preferred stock to continue its preferred status or be exchanged for a new class with the same or substantially the same preferred status without the requirement of a shareholder vote. Since an existing class of preferred stock would presumably have been authorized in the same manner as required by the regulation or have been issued in exchange for financial assistance from the supervising bank, the final regulation permits existing preferred stock to continue its preferred status or be exchanged for a class of stock with substantially the same preference without a shareholder vote provided the stock was originally authorized by the shareholders or issued to the supervising bank in return for financial assistance.

Several respondents objected to the requirement that dividends be paid on a per share basis without preference among common shareholders. One objection appeared to be based on the belief that the FCB could not pay patronage to FLBAs that are not direct lenders and that there would be no way to distribute earnings based upon the FLBA's contribution to the district's earnings. Other respondents noted that State corporation statutes often allow different dividend rates on common stock if the preferences are stated in the bylaws. One respondent requested clarification of whether the phrase "without preference" applied to the dollar divided per share or to the rate of return on the par value of each share and urged that the latter interpretation be adopted, to provide institutions the flexibility to issue different classes of stock at different par values.
The FCA continues to believe that the requirement that dividends be paid on a per share basis without preference between common shareholders is appropriate and the requirement is reflected in the final regulation. The final regulation would permit different rates of dividends on different classes of stock if preferences are stated in the bylaws. However, a class of stock that has a dividend preference is a preferred class of stock and must be authorized by all classes of stock affected by the preference in the manner required by the regulation. The FCA intends "without preference" to refer to the rate of return and the priority of payment rather than the dollar amount per share and has clarified the regulation accordingly.

The FCA knows of no reason FCBs should not be able to distribute earnings to FLBAs that are not direct lenders on the basis of their contributions to earnings. The new title I of the 1971 Act, under which FCBs operate, leaves the manner of earnings distribution to the institution's bylaws and FCA regulation. The provisions of the 1971 Act requiring stock purchased from an FLBA as a condition of obtaining a loan to be retired upon repayment of the loan, as well as the provisions requiring an FLBA to purchase an amount of stock in the FLB equal to the amount of stock purchased by the borrower in the FLBA, have been repealed. Therefore, for equities issued after October 5, 1988, the concept of "pass-through" equities is no longer relevant. Also the requirement for the patronage refund of the long term real estate lender to be paid to borrowers, rather than to FLBAs, has been repealed. Thus, it would appear that FCBs and FLBAs that are not direct lenders have more flexibility in structuring their relationship than they have had in the past, including the potential for distributing earnings on some type of patronage basis. Furthermore, the compensation agreements between the FCB and the FLBAs that are not direct lenders would appear to provide additional flexibility for the distribution of earnings on the basis of the institution's contribution to them. Therefore, the final regulation continues to require that dividends be paid on a per share basis without preference among all common shareholders and participation certificate holders.

One respondent expressed a concern that the requirement that earnings pools be so structured as to ensure that each patron of the institution receives its fair share of earnings and bear its fair share of expenses may be so rigidly expressed as to require an institution to differentiate between the cost of servicing a $100,000 loan and a $20,000 loan. The respondent suggested that this requirement be qualified by adding the phrase "to the extent feasible and practical as determined by the board." Another respondent stated that any requirement beyond a requirement that such pools be established on a rational and equitable basis is unnecessary in light of general cooperative principles and in light of provisions of the Internal Revenue Code dealing with patronage refunds. This respondent thought the additional language intended to ensure that each patron receives a fair share of earnings and bears a fair share of expenses would merely create uncertainty as to what actually is being required in determining equitable patronage refunds.

While the FCA believes it important to give more guidance than the requirement for a "rational and equitable" basis would give, the additional language is intended to be understood as a general principle upon which earnings pools should be structured. The institution's board must obviously take into account practicality and feasibility in implementing the principle, as must the FCA in enforcing it. The FCA believes that the addition of the suggested language is not necessary.

A clarification of the term "proportionate basis" was requested by one respondent. The term "proportionate basis as determined by the board" in 615.5230(b)(3) was intended to give the board broad discretion in determining the basis for the distribution but to require that there be some basis for the distribution that is equitable and nondiscriminatory in nature. In the final regulation, the words "equitable and nondiscriminatory basis" have been substituted for "proportionate basis."

One respondent suggested that paragraph (b)(4) of 615.5230 of the proposed regulation be modified to acknowledge that classes of stock resulting from a conversion of allocated surplus may be accorded the same priority as other classes of stock. The FCA believes the regulation as presently worded already permits this result, inasmuch as the language of paragraph (b)(4) merely excepts classes of stock resulting from a conversion of allocated surplus from the requirement to be accorded the same priority. However, institutions should consider whether according such classes of stock the same priority is equitable to other shareholders.

The respondent also requested that the regulation provide the priorities necessary for restoration of an impairment of protected stock. Although the institution's bylaws must obviously provide for protected stock, Subpart I of the regulation does not address protected stock.

Section 615.5240 -- Permanent Capital

A few respondents challenged the FCA's interpretation of the 1987 Act to require that all stock issued after October 5, 1988, have the characteristics of permanent capital. One respondent opined that the 1971 Act clearly allows automatic retirement and revolvement plans if such plans allow the board of directors to discontinue them at its discretion, so long as borrowers are advised of this limitation and the fact that stock may not be retired if the institution fails to satisfy the minimum permanent capital adequacy standard.

The FCA reaffirms its position that no stock may be issued by Farm Credit institutions after October 5, 1988, that is not both at-risk and retireable at the discretion of the board of directors provided minimum capital adequacy standards are met. These are the essential characteristics of permanent capital. These requirements necessarily preclude the issuance of stock that is retireable upon repayment of the loan or subject to an automatic retirement plan that operates to retire stock automatically as the loan is paid down without a conscious decision to retire stock after an evaluation by the board of the capital position of the institution. In addition, respondents who argue that it was not the intent of Congress to prohibit the issuance of stock that is retireable upon the repayment of the loan have overlooked a clear statement to the contrary in the legislative history. The Conference Report, in describing the provisions of S. 1665 that were incorporated in the 1987 Act relating to the capitalization bylaws, stated:

The Senate amendment will prohibit after the adoption of the new bylaws, the issuance by FCS institutions of stock that can be retired by the holder when he repays his loan, or otherwise at the option or request of the holder. (Sec. 4.3A(c)(1)(A)).

H.R. Rep. No. 490, 100th Cong., 1st Sess. 247 (1988). The Senate provision was adopted in preference to a provision in H.R. 3030 that stated that the bylaws need not provide for retirement of stock on repayment of the loan, which would have had the effect respondents contend the 1987 Act has. Equities issued subject to automatic retirement plans that operate without a conscious evaluation by the board of the institution's capital position prior to each decision to retire equities are impermissible because such stock is essentially retireable at the option of the holder, who has only to pay down the loan to retire the equities. Such plans would make it impossible to ascertain whether the statutory prohibition against retiring equities were violated until after the equities had been retired, making enforcement of the statutory prohibition difficult at best.

The final regulation would not preclude periodic stock retirements as loans are paid down, provided the decision is consciously made after an evaluation of the institution's capital position and a determination that interim minimum permanent capital standards would continue to be met. In allowing such retirements, due consideration must also be given to achieving reasonable progress toward the 7 percent minimum permanent capital standard, and, of course, such decisions must be nondiscriminatory as between equityholders. Retirements made under these circumstances would not be regarded as made pursuant to an automatic retirement or revolvement plans. However, institutions must take care not to create unrealistic expectations on the part of borrowers about the likelihood that such retirements will occur and should begin the task of re-educating borrowers concerning the change in the focus of capitalization wrought by the 1987 Act from capitalizing the loan to capitalizing the institution.

It is equally clear that equities issued under the new capitalization bylaws must be at risk. Stock and participation certificates in System institutions are and always have been equity investments. The very nature of equity is that the holder bears the risks of ownership, including the loss of the investment. Outstanding equity investments in System institutions were afforded protection from loss by the 1987 Act, but that protection is not available for equities issued after October 5, 1988. If institutions were to issue stock that is not at risk, such investments would not be equity, but debt. Therefore, the FCA reaffirms its position that the 1987 Act has the effect of prohibiting institutions from issuing equities other than those that are retireable at the option of the board (and not upon repayment of the loan or otherwise at the option of the holder) and are retireable at no more than book value.

One respondent noted that 615.5240(a)(1)(ii) and 615.5240 (a)(2)(ii) do not preclude the board of directors from further limiting the retirement value of at-risk stock to book value not to exceed par value and suggested that to retire stock at more than par value may have certain securities law implications. The FCA confirms the respondent's interpretation of the regulation. If an institution wishes to provide in its bylaws that stock is retireable at book value not to exceed par, the final regulation would not preclude it. Since the 1987 Act is silent on this issue and the FCA did not regard retirement at book value not to exceed par as a critical cooperative principle, the FCA believed institutions should have the flexibility to determine this issue for themselves.

The respondent also requested clarification as to the applicability, if any, of 615.5240(a)(1)(iv) and (a)(2)(iii) to patronage refunds, in view of the distinction made in the regulation between dividends and patronage refunds. Section 615.5240(a)(1)(iv), which states that dividends must be payable only at the discretion of the board and must be noncumulative, has no application to patronage refunds. Similarly, 615.5240(a)(2)(iii), which allows dividends to be cumulative on preferred stock, has no application to patronage refunds. The FCA does not understand why the clarification is necessary because it does not understand how a patronage refund could be cumulative.

A number of respondents objected to requirement to subordinate the obligation to pay cumulative unpaid dividends to the rights of the holders of common stock and participation certificates to have their stock or participation certificates retired at book value not to exceed par upon liquidation and asserted that such a provision is without statutory basis. Some objected to the requirement that such dividends be capable of indefinite deferment as well.

The purpose of this provision was to ensure that any preferred stock that is issued does not take on the character of debt. While holders of preferred stock with cumulative dividends have a right to the payment of cumulated but unpaid dividends prior to the distribution of any other earnings, the FCA believed that such preferred stock would begin to resemble debt if the accumulated but unpaid dividends were required to be satisfied upon liquidation prior to the rights of common shareholders to have their stock retired at book value not to exceed par upon liquidation. After considering the comments relating to the potential impact of the restriction on the ability to market preferred stock, the FCA concluded that the provision would be unnecessarily restrictive. The preferred stock itself is at risk, which is sufficient to qualify the stock as permanent capital. Common shareholders are adequately protected by their ability to vote on the issuance of preferred stock. For these reasons, the restrictions on cumulative dividends on preferred stock have been eliminated in the final regulation.

Many respondents, especially associations, objected strenuously to paragraph (b) of this section, which would require the capitalization bylaws to allow the Farm Credit Bank to require the holders of its common stock and participation certificates to subscribe for such additional capital as may be needed by the Farm Credit Bank to meet its capital requirements or its obligations under joint and several liability. These respondents asserted that the FCA is without statutory authority to adopt such a regulation since the 1987 Act repealed the specific capitalization provisions that gave the FCB authority to make such calls on the associations.

The Funding Corporation, on the other hand, strongly supported the regulation. They argued that the regulation is appropriate because the banks and associations are an integrated credit delivery system that depends on the combined strength of the institutions to obtain funding at favorable rates on the basis of combined financial statements. The Funding Corporation further asserted that the capital call provision would remove the incentive for districts to artificially shift capital between the banks and associations for the purpose of minimizing the Districts' exposure on Systemwide obligations under the joint and several liability provisions of section 4.4 of the 1971 Act. The Funding Corporation and other respondents also objected to the inclusion of owners of participation certificates (institutions other than System institutions that discount with the FCB, or OFIs) within the ambit of this paragraph, inasmuch as they have no voting rights with respect to either the bylaws or the operations of the FCB. Also, the respondents asserted, OFIs are free to seek funds from whatever sources offer the best terms at the moment and are under no obligation to provide long-term support to the FCBs. Since the financial statements of OFIs are not combined with those of System institutions in the financial statements issued to System investors, the Funding Corporation thought that the case to be made for the proposed regulation would be strengthened by excluding OFIs from the applicability of this paragraph.

Under the proposed regulation, capital calls by the banks on the associations would require the prior approval of the FCA and would be required to take into account the financial condition of their shareholders. Several respondents objected to the requirement for prior approval by the FCA, arguing that this requirement is inconsistent with the rationale under which Congress removed FCA's approval authority with respect to loss sharing agreements and that the FCA should not have veto power over the banks' authority to make such calls. One respondent noted that under the FCA's capital adequacy regulation, as originally proposed on May 12, 1988, an FCB would have been unable to meet its capital requirements through such capital calls, since the proposed regulation would have required the FCB to deduct the association's investment in the bank from its capital to eliminate the double counting of capital.

Despite the assertion that a negative inference concerning the banks' authority to make capital calls on associations arises from the deletion of the specific capitalization provisions of the 1971 Act, the FCA continues to believe that a reasonable argument can be made to support the regulation. The FCA continues to have, after the 1987 Act, general rulemaking authority and specific authority to regulate the transfer of funds between institutions. The 1987 Act did not change the funding mechanism or the funding relationship between the bank and the associations. While Congress clearly intended to promote the autonomy of the associations in adopting the 1987 Act, it is equally clear that the associations remain dependent upon the bank for funding and cannot long survive the demise of the banks. Thus, in that sense, the System remains an integrate credit delivery system as the Funding Corporation contends. It is also clear that the beneficiaries of the preferred access to funding and the benefits of more favorable rates that result from joint and several liability on consolidated Systemwide bonds are the associations and their borrows. If banks are unable to have access to capital in the associations, investors may demand higher returns for what they perceive to be greater risk, which will ultimately be passed on to the associations and their borrowers in the form of higher interest rates.

After considering the comments in the light of the 1987 Act and its legislative history, the FCA has concluded that while a reasonable argument can be made that there is statutory authority for such a regulation, the need for such a regulation may be offset by the fact that the likelihood of a capital call on associates to honor obligations under joint and several liability is more remote than it was prior to the 1987 Act. After 1993, joint and several liability is triggered only after the funds of the Farm Credit System Insurance Corporation (FCSIC) are exhausted. When it is triggered, calls are made on banks in proportion to their available collateral, which suggests that Congress contemplated that the maturing bonds would be refunded by new debt backed by the available collateral, as such calls have historically been handled. Only after all available collateral is exhausted would the call be made on banks in proportion to their assets and only at that point is the bank likely to need assistance from the associations to honor joint and several obligations. This is not likely to occur unless all banks in the System were simultaneously weakened to the point of non-viability. Thus, in light of the reduced likelihood of invoking joint and several liability after FCSIC is operational and fully funded, and in view of the fact that the 1971 Act appears to contemplate that such obligations would be honored by refunding the obligation using available collateral, the FCA has concluded that such a regulation is not required at this time. Therefore, the capital call provision is deleted in the final regulation.

Nevertheless, associations have an ongoing obligation to ensure that the bank is adequately capitalized and the bank has an obligation to take into account all of its risk, including joint and several liability, in setting its total capital requirements. The lack of the ability of the bank to make specific capital calls may undercut the ability of the System banks to sell bonds on the basis of the combined financial statements of the banks and associations and may mean that System banks will pay a higher price for their funding. Therefore, the FCA encourages FCBs and their associations to enter into contractual agreements or develop some mechanism in the bank bylaws that will obligate associations to support joint and several liability. The FCA encourages FCBs to take into account the absence of such agreements in determining their total capital requirements and in making decisions to downstream capital to the associations. Also, the FCA will consider the presence or absence of such agreements or other arrangements for supporting joint and several liability in evaluating the adequacy of total capital in each FCB and FICB.

A number of respondents objected to paragraph (c) of this section (redesignated as paragraph (b) in the final regulation), which provides that until an institution meets its minimum permanent capital standard, all equities required to be purchased as a condition for obtaining a loan must be purchased from the institution. Some asserted that it violates section 4.3A(c)(1)(J) of the 1971 Act, which requires stock to be transferable, by limiting the uses of transferred stock. Others were concerned that it would make marketing efforts more difficult and result in a loss of borrowers. One respondent stated its' interpretation of the proposed regulation as not prohibiting the borrowers from utilizing stock they already own which cannot be retired because of the statutory prohibition to support new loans or increased borrowings against lines of credit.

The FCA does not agree that the requirements of paragraph (c) are inconsistent with the requirements of section 4.3A(c)(1)(J) of the 1971 Act requiring stock to be transferable. A requirement that qualifying shares of stock be purchased from the institution when the institution does not meet its capital standards does not restrict transfer rights. The FCA believes that such a requirement is necessary to avoid circumvention of the statutory prohibition against reducing permanent capital by retiring stock or redistributing earnings when an institution does not meet its capital standards. To allow the transfer under such circumstances would defeat the purpose of the statutory prohibition because the institution would be in the same capital position if new borrowers were to purchase qualifying shares from existing borrowers as if it had retired stock. To allow such transfers would make it very difficult for institutions to make progress toward their capital goals. The regulation is not intended to require existing borrowers to purchase additional stock to support new loans if their stock cannot be retired because of the statutory prohibition. However, all stock supporting new loans made after October 5, 1988, must be at-risk stock, and if a borrower wishes to use eligible borrower stock to support such a loan, rather than having his or her stock retired, such stock must be converted to at-risk stock. Eligible borrower stock is, of course, not subject to the statutory prohibition and can be retired even when minimum permanent capital standards are not met.

Section 615.5250 -- Disclosure Requirements

Several respondents requested clarification of the disclosure requirements when stock is sold to existing borrowers for investment purposes rather than to satisfy the stock purchase requirement. The FCA provides the following clarification: When stock is sold to an existing borrower as an investment in addition to the stock required to be purchased as a condition of obtaining a loan, the disclosure requirements of paragraph (d)(1) (designated as paragraph (c)(1) in the proposed regulation) apply.

The regulation contemplates that sales of stock other than those made to borrowers in connection with obtaining a loan would be required to be authorized by the shareholders and sold pursuant to a disclosure statement. If there is a desire to sell additional stock as an investment to existing borrowers from time to time upon request, shareholders could authorize a number of shares to be issued from time to time in the discretion of the board pursuant to a disclosure statement that could be easily updated by incorporating by reference the most recent annual and quarterly reports. For the purpose of selling additional stock to shareholders, there is no need to provide an additional copy of any materials that have previously been sent to the shareholders, provided such materials are recent enough to meet the requirements of paragraph (d)(1), unless the prospective purchasers request an additional copy. However, the disclosure statement describing the terms and conditions under which the equity is issued, including an express disclosure that the equity is retireable only at the discretion of the board of directors and is an investment that is at risk and not a compensating balance, must be given to the purchaser at the time of each purchase. The final regulation has been expanded to clarify that the institution need not provide annual reports, quarterly reports and capitalization bylaws to existing borrowers at the time of purchase of stock for investment if such materials have already been sent to shareholders, unless the borrower requests.

Paragraph (a)(4) of 615.5250 has been expanded in the final regulation to clarify that disclosing terms and conditions of the equity involves disclosure of the statutory prohibition on the retirement of stock and distribution of earnings in cash if the institution does not meet its minimum permanent capital standards (including interim standards), as well as disclosure of whether the institution meets its standard at the time of purchase and whether the institution knows of any reason it will not meet its standard on the next earnings distribution date.

One respondent pointed out two technical errors in this section in the regulatory references and in the designation of paragraphs. The technical errors have been corrected in the final regulation. The last paragraph in this section has been redesignated as paragraph (d). The reference in 615.5250(c)(2) to paragraph (b)(1) of the section has been changed to paragraph (c)(1).

C. Subpart J -- Retirement of Equities

Section 615.5260 -- Retirement of Eligible Borrower of Stock

Several respondents challenged the FCA's statutory authority to regulate the retirement of protected stock, inasmuch as eligible borrower stock does not qualify as permanent capital and the 1971 Act requires that it be retired at par. These comments appear to be based on the assumption that the FCA's only authority to regulate in the capital area is section 4.3A of the 1971 Act. They overlook the specific reference to FCA regulations in sections 1.4, 2.3, 2.13 and 3.25 of the 1971 Act, which grant institutions authority to provide for capitalization and for the issuance and retirement of equities and distribution of earnings in their bylaws. They also fail to take into account the FCA's general rulemaking authority and the fact that all corporate authorities are granted subject to FCA regulation. Furthermore, the 1987 Act did nothing to change the FCA's responsibilities as the regulator of System institutions to exercise all its authorities to promote the safe and sound operation of the System and to carry out the purposes of the 1971 Act.

The FCA regards the early retirement of eligible borrower stock as a safety and soundness issue even though the borrower is protected from loss. The fact that the borrower is protected from loss does not mean that the stock ceases to function for creditors as a cushion from loss and as an earnings base. The FCA's concern with capital levels is not limited to assuring that the minimum standard is met. The FCA must necessarily concern itself with the level of an institution's total capital in light of the particular circumstances of each institution. The minimum capital standard is established as a minimum level for a well managed institution during more or less normal business cycles. The minimum permanent capital standard is not intended to define an adequate level of capital for all institutions. Furthermore, the minimum standard will not be fully phased-in until 1993. During the phase-in period, much of the total capital of an institution is comprised of eligible borrower stock. To ignore the levels of total capital would, especially during the phase-in period, constitute an abdication of the FCA's responsibility to promote the safe and sound operation of the System institutions. In addition, without such oversight, it would be possible for institutions that wish to leave the System to circumvent the requirement of the 1987 Act to pay over to FCSIC all of its capital in excess of 6 percent of its assets when it leaves the System.
One respondent recommended that if the requirement is adopted, the definition of "retirement in the ordinary course of business" be expanded to include servicing actions such as restructurings, reamortizations, formal extensions or voluntary exchanges of protected stock for at-risk stock. The final regulation adds to the definition of "ordinary course of business" any retirement that occurs pursuant to 615.5290 -- Retirement in event of restructuring, which was added by the borrower rights regulations adopted by the FCA on September 6, 1988, and published on September 14, 1988 (53 FR 35427), and any retirement that is necessary to accomplish an exchange of eligible borrower stock for a like amount of at-risk stock.

The respondent also suggested that the FCA should consider whether 615.5260(a)(3)(iii), which allows participation certificates and allocated surplus issued under a revolving plan to be retired at a discount when they are retired early, should also apply to stock issued subject to a revolving plan. The FCA has considered the comment, but does not believe it appropriate to change the regulation. The regulation incorporates a statutory definition that defines "par value" for stock as "par value" and does not make any exceptions for stock issued subject to a revolvement plan. The FCA recognizes that the term "allocated equities," which is used in the statutory definition, is sometimes used to include stock that has been allocated as a distribution of earnings, but believes that it is not used in that sense here. If it had been used in that sense, it would have also included participation certificates, which are specifically referenced. To give the statute the reading suggested by the respondent would limit the protection to borrowers provided under the statute. The FCA does not believe the legislative history provides clear support for such an interpretation.

As noted by several respondents, the Technical Corrections Act removed the statutory basis for the second sentence in 615.5260 (b) and (c), which provides that retirement of eligible borrower stock should be coordinated with the Farm Credit System Financial Assistance Board (FAB) and the Farm Credit System Assistance Corporation (FAC), if the institution's stock is impaired. Accordingly, this sentence has been deleted in the final regulation.

One respondent urged that 615.5220(f) of the proposed regulation (redesignated as paragraph (g) in the final regulation) be revised to apply only to the retirement of permanent capital because stock issued to PCAs in the mandatory merger of the FLB and the FICB in the respondent's district is neither protected stock nor considered permanent capital under the proposed capital adequacy regulations published on May 12, 1988. The FCA knows of no reason that such stock would not be considered permanent capital and believes that respondent may be referring to the exclusion of the PCA's investment from the bank's permanent capital that would have been required under the May 12, 1988 proposed capital adequacy regulations to eliminate double counting of capital. Such an exclusion would have been made to eliminate double counting and did not mean that the stock would not have the characteristics of permanent capital. Nevertheless, the respondent raises a point that should be addressed. It is possible that there may be classes of stock presently outstanding that are not permanent capital and are not protected stock, and the bylaws will need to make provision for them, as well as for protected stock. As noted earlier, 615.5220(f) only relates to the bylaws that must be approved by shareholders and applies to stock issued after October 5, 1988, and no change is needed in 615.5220(f). However, as a result of the point raised in connection with 615.5220(f), the FCA concluded that 615.5270(a) should be revised in the final regulation to delete the words "retireable only in the discretion of the board and not on a date certain or upon the happening of an event such as repayment of a loan or pursuant to an automatic retirement or revolvement plan." With respect to stock issued after October 5, 1988, such language is duplicative of 615.5220(f). Subpart J, unlike Subpart I, is not limited to equities issued after October 5, 1988, and is thus amended to accommodate the existence of any presently outstanding stock that may be neither permanent capital or protected stock.

One respondent requested clarification of the coordination of 615.5270 (b) with 615.5280. Section 615.5270(b) states that equities may not be retired unless after the retirement the institution would continue to meet the minimum permanent capital standards (including interim standards) established by the FCA under Subpart H. Section 615.5280 allows stock and participation certificates to be retired and the proceeds applied to the borrower's loan in the event of default. The respondent requested confirmation of its interpretation that retirement under 615.5280 is required even if an institution does not meet its minimum capital adequacy standard.

The clarification sought by the respondent is provided by section 4.3A(f) of the 1971 Act, which states that section 4.3A does not affect the statutory lien of System institutions on the borrower's stock or the privilege of applying such stock to the borrower's indebtedness in event of default or restructuring. This clarification has been made explicit in the final regulation by adding an exception to 615.5270(b) referencing 615.5280 (Retirement in event of default) and 615.5290 (Retirement in event of restructuring). The FCA notes however, that 615.5280 is permissive and does not require retirements in event of default. The FCA also amends 615.5215 of the capital adequacy regulation adopted on September 28, 1988, which sets forth the statutory prohibition, to clarify that retirements pursuant to 615.5280 and 615.5290 are not subject to the prohibition.

One respondent noted that no provision is made in the proposed regulation for the FCB to retire stock in the event of default. The final regulation has been expanded by adding a new paragraph (d) in 615.5280 that authorizes the FCB to retire, at book value not to exceed par, any of its equities on which the FCB has a lien to secure a borrower's indebtedness when the borrower's loan is in default. Subsequent paragraphs in 615.5280 have been redesignated accordingly.

Another respondent pointed out that 615.5280 does not address retirements that are required by section 4.14B (a) and (b) of the 1971 Act when a loan is restructured and principal is forgiven and written off and made a number of comments suggesting that the various provisions of section 4.14B be referenced in 615.5280. Retirements of stock in connection with restructuring under section 4.14A area addressed in the borrower rights regulations adopted by the FCA on September 6, 1988 (53 FR 35427), September 14, 1988) and hence there is no need to reference them in 615.5280.

The respondent requested clarification of the term "fair market value" in 615.5280(c), which allows BCs to apply stock, except eligible borrower stock, to the borrower's indebtedness at "fair market value." In proposing this section, the FCA inadvertently omitted the words "not to exceed par" after fair market value. Fair market value is a term used in the 1971 Act prior to amendment and in the prior regulation and in that context meant its par value discounted to take into account its early retirement. In the final regulation, this language has been clarified to state that stock other than eligible borrower stock that has been issued subject to a revolving plan may be applied to the borrower's indebtedness at its present value on the date of retirement.

The respondent noted that the notification requirements of 615.5280(e) are no longer a statutory requirement and recommended that they be deleted from the regulation. The FCA is aware that such notice is no longer required by statute, but believes that the giving of such notice is an issue of fundamental fairness to shareholders and that such a regulation is within the FCA's statutory authority to regulate disclosure to shareholders. However, a new paragraph (h) of the section has been added to provide that the notice may be satisfied by the notices required by 614.4516, 614.4518, 614.4519 of the FCA's borrower rights regulations in appropriate circumstances.

The respondent also stated 615.5280(e) should reference the requirement of section 4.14B(c) that the borrower be allowed to keep at least one share of voting stock when the loan is restructured and a portion of the principal is forgiven and written off. The FCA did not accept this recommendation. The requirement of 615.5280(e)(2) of the proposed regulation (redesignated as paragraph (f)(2) in the final regulation) that the borrower be unformed that all or part of his or her stock investment may be retired in total or partial liquidation of the loan merely requires the institution to state its intention with respect to the retirement. Since not every borrower who defaults will be eligible for restructuring, the institution is not required to leave every borrower who defaults with one share of voting stock. Retirement in event of restructuring is dealt with in 615.5290 and the requirement referred to by the respondent is referenced therein.

In the proposed capital adequacy related regulation published on September 2, 1988, the FCA referred to the FCA's proposed borrower rights regulations (53 FR 16937) which proposed to add paragraphs (e) and (f) to existing 615.5255. The FCA stated that if the September 2, 1988 proposal were adopted as a final regulation, the paragraphs added by the borrower rights regulations would be redesignated as paragraphs (f) and (g), respectively. The FCA's borrower rights regulations have now been adopted as final regulations (53 FR 35427), but these paragraphs have been incorporated as a revision of 615.5290 and it is unnecessary to redesignate them. All existing sections of Subpart J are deleted or amended by this final regulation.

D. Subpart K -- Surplus and Reserves

A number of respondents asserted that the requirements for a BC to add to unallocated surplus 10 percent of net earnings after taxes until such time as the unallocated surplus equals half of the minimum permanent capital requirements established under Subpart H is without statutory basis and an intrusion into the management of privately owned institutions. One respondent referred to a line of tax cases establishing precedent for board discretion in deciding appropriations of earnings, which rely upon the fact that cooperatives are private institutions governed by a duly elected board with authority from shareholders to make earnings appropriations decisions. The respondent also asserted that the requirements to withhold a certain percentage from earnings' distributions could cause a BC to be noncompetitive because patronage would be reduced, which could hamper efforts to attract new business. The respondent also noted that the practice in BCs has been to determine the percentage amount of earnings to appropriate to allocated surplus before taxes, with the amount that is actually added to the unallocated surplus being net of taxes. Another respondent viewed the requirement as an attempt to define the form the BC permanent capital must take.

The argument that the FCA is without statutory authority to adopt such a regulation is without merit. In addition to its general rulemaking authority, there is specific authority for the FCA to enact regulations that

* * * provide for the application of net savings to the restoration or maintenance of an allocated surplus account, reasonable additions to unallocated surplus, or to unallocated reserve after payment of operating expenses and provide for allocations to patrons not qualified under the Internal Revenue Code, or payment of such percentum of patronage refunds in cash, as the board may determine.

Section 3.11(a) of the 1971 Act, 12 U.S.C. 2132(a). This statutory provision has been in effect since 1971 and must have been taken into account by any tax cases handed down since 1971. While it is not possible to comment on the relevance of the tax cases referred to by the respondent, since no specific cases were cited, it is safe to say that cases supporting board discretion in determining board discretion in allocating earnings in a tax context may have little relevance to the authority of the FCA to regulate in this area.

Nor does the FCA believe that it can reasonably be argued that the specific provisions of section 3.11(a) are inconsistent with the provisions of section 4.3A, even though there is no specific reference to FCA regulations in section 4.3A. In adopting a new Title I of the 1971 Act to govern the operations of the FCBs, and a new Title II to govern the operation of the associations, Congress affirmed the authority of the FCA to regulate the issuance and retirement of equities and the distribution of earnings in all other institutions. The Technical Corrections Act amended section 3.25 of the 1971 Act to add language identical to the language in new Titles I and II that affirms the authority of the FCA to regulate in this area with respect to the National Bank for Cooperatives. It is unlikely that the Congress intended FCA to have such authority with respect to all banks and associations except the BCs that voted not to join the National Bank for Cooperatives.

At the present time the FCA considers the level of capital funds of the BCs not allocated to the borrowers relatively small in relation to the size and scope of operations of the BCs. The FCA believes that, in the interest of safety and soundness, the institution should have a level of capital that is not allocated to borrowers to allow the institution more flexibility in times of adverse economic conditions. Under adverse economic conditions the bank may be required to add substantial amounts to its reserve for losses. If such additions impair borrowers' equities, borrowers may be unwilling to purchase additional equities just as a commercial bank with impaired stock may find selling additional stock nearly impossible. FCA believes that a buffer between allocated equities and the reserve for loan losses in the form of unallocated surplus is both necessary and desirable to ensure the long term safety and soundness of the BCs.

FCA does not agree that the requirement to add 10 percent to surplus until the surplus reaches 50 percent of the minimum permanent capital requirement is so burdensome as to discourage new loan volume and believes that it will provide more flexibility to the institution in managing its operations. As noted in the preamble of the proposed regulation, the requirement is less stringent than the standards adopted by the FCCA as a Systemwide standard in 1985. Nor does the FCA agree that expressing the requirement in terms of after-tax dollars is unworkable. The regulation would require that taxes be estimated prior to the determination of the amount to be added to unallocated surplus.

The FCA emphasizes that the final regulation does not require an institution to achieve any particular level of unallocated surplus in any given year and no adverse consequences flow from failure to achieve a level equal to 50 percent of the minimum capital requirements. It merely requires that when there are earnings, a small portion of them be added to unallocated surplus until the unallocated surplus reaches a certain level, when the requirement is no longer applicable. The requirement is based on the safety and soundness concerns discussed above.

The final regulation therefore retains the requirement of 615.5330 as originally proposed, but modifies the requirement to clarify that the minimum capital standard referred to is the 7 percent minimum permanent capital standard.

As proposed, Subparts L, M, and N are removed and reserved.

List of Subjects in 12 CFR Part 615

Accounting, Agriculture, Banks, Banking, Government securities, Investments, Rural areas.

For the reasons stated in the preamble, Part 615 of Chapter VI of Title 12 of the Code of Federal Regulations is amended as follows:

PART 615 -- FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS, AND FUNDING OPERATIONS

1. The authority citation for Part 615 is revised to read as follows:

Authority: Secs. 3.11, 3.25, 4.3, 4.9, 4.14B, 5.9, 5.17, 6.20, 6.26; 12 U.S.C. 2132, 2146, 2154, 2160, 2202b, 2243, 2252, 2278b, 2278b-6; sec. 301(a) of Pub. L. 100-233.

615.5215 [Amended]

2. Subpart H, 615.5215, is amended by adding the phrase, "except retirements pursuant to 615.5280 and 615.5290" after the words "allocated equities" in the first sentence.

3. Subpart I is revised to read as follows:

Subpart I -- Issuance of Equities

Sec.

615.5220 Capitalization bylaws.

615.5230 Implementation of cooperative principles.

615.5240 Permanent capital requirements.

615.5250 Disclosure requirements.

Subpart I -- Issuance of Equities

615.5220 Capitalization bylaws.

The board of directors of each System bank and association shall, pursuant to section 4.3A of the Farm Credit Act of 1971 (Act), adopt capitalization bylaws, subject to the approval of its voting shareholders that set forth:

(a) Classes of equities and the manner in which they shall be issued, transferred, converted and retired;

(b) For each class of equities, a description of the class(es) of persons to whom such stock may be issued, voting rights, dividend rights and preferences, and priority upon liquidation, including rights, if any, to share in the distribution of the residual estate;

(c) The number of shares and par value of equities authorized to be issued for each class of equities, except that equities that are required to be purchased as a condition of obtaining a loan and nonvoting stock into which voting stock is converted after repayment of the loan may be authorized to be issued in unlimited amounts;

(d) For Farm Credit Banks and associations, the percentage or dollar amount of equity investment (which may be expressed as a range within which the board of directors may from time to time determine the requirement) that will be required to be purchased as a condition for obtaining a loan, which amount may be more than, but shall be not less than, 2 percent of the loan amount or $1,000, whichever is less;

(e) For banks for cooperatives, the percentage or dollar amount of equity or guaranty fund investment (which may be expressed as a range within which the board may from time to time determine the requirement) that serves as a target level of investment in the bank for patronage-sourced business, which amount may be more than, but shall not be less than, 2 percent of the loan amount or $1,000, whichever is less;

(f) The amount of voting stock protected under section 4.9A of the Act that existing borrowers will be required to exchange for new voting stock issued under capitalization bylaws adopted pursuant to section 4.3A of the Act;

(g) The manner in which equities will be retired, including a provision stating that equities other than those protected under section 4.9A of the Act are retireable at the sole discretion of the board, provided minimum permanent capital adequacy standards (including interim standards) established in Subpart H of this part are met;

(h) The manner in which earnings will be allocated and distributed, including the basis on which patronage refunds will paid, which shall be in accord with cooperative principles; and

(i) For Farm Credit banks, the manner in which the capitalization requirements of the Farm Credit Bank shall be allocated and equalized from time to time among its owners.

615.5230 Implementation of cooperative principles.

(a) Voting shareholders of Farm Credit banks and associations shall be accorded full voting rights in accordance with cooperative principles.

(1) Voting shareholders of associations and banks for cooperatives shall:

(i) Have only one vote, regardless of the number of shares owned or the number of loans outstanding, except a otherwise required by statute or regulation and except as modified by paragraph (b) of this section;

(ii) Be accorded the right to vote in the election of each director and, unless otherwise provided in the capitalization bylaws, be allowed to cumulate such votes and distribute them among the candidates in the shareholder's discretion.

(2) Each voting shareholder of a Farm Credit Bank shall:

(i) Have one vote that is assigned a weight proportional to the number of the association's voting shareholders in a manner that does not discriminate against agricultural credit associations that have resulted from the merger or consolidation of Federal land bank associations and production credit associations; and

(ii) Have the right to vote in the election of each director and, unless otherwise agreed to by each association shareholder, be allowed to cumulate such votes and distribute them among the candidates in the shareholder's discretion.

(3) Notwithstanding the provisions of paragraph (a)(1)(ii) of this section, any association that presently elects directors on a regional basis may continue to do so until January 1, 1993.

(b) Each equityholder of each institution shall be equitably treated in the operation of the institution.

(1) Each issuance of preferred stock (other than preferred stock to be issued to the Farm Credit System Financial Assistance Corporation and preferred stock outstanding on October 5, 1988, and stock into which such outstanding stock is converted that has substantially similar preferences) shall be approved by a majority of the shares of each class of equities affected by the preference, voting as a class, whether or not such classes are otherwise authorized to vote;

(2) Any dividends paid to the holders of common stock and participation certificates shall be on a per share basis and without preference as to rate or priority of payment between classes of common stock, between classes of participation certificates, between classes of common stock and classes of participation certificates, or between holders of the same class of stock or participation certificates, except that any class of common stock or participation certificates that result from the conversion of allocated surplus may be subordinated to other classes of common stock and participation certificates in the payment of dividends.

(3) Any patronage refunds that are paid shall be paid in accordance with cooperative principles, on an equitable and nondiscriminatory basis determined by the board of directors in accordance with the capitalization bylaws, provided that any earning pools that may be established for the payment of patronage shall be established on a rational and equitable basis that will ensure that each patron of the institution receives its fair share of the earnings of the institution and bears its fair share of the expenses of the institution.

(4) All classes of common stock and participation certificates (except those resulting from a conversion of allocated surplus) must be accorded the same priority with respect to implement and restoration of impairment and have the same rights and priority upon liquidation.

615.5240 Permanent capital requirements.

The capitalization bylaws shall enable the institution to meet the minimum permanent capital adequacy standards (including interim standards) established under Subpart H of this Part and the total capital requirements established by the board of directors of the institution.

(a) In order to qualify as permanent capital, equities issued under the bylaws must meet the following requirements:

(1) For common stock and participation certificates --

(i) Retirement must be solely at the discretion of the board of directors and not upon a date certain or upon the happening of any event, such as repayment of the loan, and not pursuant to any automatic retirement or revolvement plan;

(ii) Retirement must be at not more than book value;

(iii) Disclosure must have been made pursuant to 615.5250 of the nature of the investment and the terms and conditions under which it is issued, and the rights, if any, to share in any patronage distributions that may be made.

(iv) Dividends must be payable only at the discretion of the board and must be noncumulative.

(2) For preferred stock issued to persons other than the Farm Credit System Financial Assistance Corporation --

(i) Retirement must be solely at the discretion of the board of directors and not upon a date certain or upon the happening of any event, such as repayment of the loan, and not pursuant to any automatic retirement or revolvement plan;

(ii) Retirement must be at not more than book value;

(iii) Dividends must be payable only in the discretion of the board, and may be cumulative; and

(iv) Disclosure must have been made pursuant to 615.5250 of the nature of the investment and the terms and conditions under which it is issued.

(b) Until a bank or association meets the minimum permanent capital standards (including interim standards) established by the FCA under Subpart H of this part, all equities required to be purchased as a condition for obtaining a loan shall be purchased from the institution.

615.5250 Disclosure requirements.

(a) Equities purchased as a condition for obtaining a loan. Prior to loan closing, the institution shall provide the prospective borrower with the following:

(1) The institution's most recent annual report filed under 12 CFR Part 620;

(2) The institution's most recent quarterly report filed under 12 CFR Part 620, if more recent than the annual report;

(3) A copy of the institution's capitalization bylaws; and

(4) A written description of the terms and conditions under which the equity is issued. In addition to specific terms and conditions, the description shall disclose:

(i) That the equity is an at-risk investment and not a compensating balance;

(ii) That the equity is retireable only at the discretion of the board of directors and only if minimum permanent capital standards (including interim standards) established under Subpart H of this part are met;

(iii) Whether the institution presently meets its minimum permanent capital standards, including interim standards; and

(iv) Whether the institution knows of any reason the institution may not meet its permanent capital standard on the next earnings distribution date.

(b) Notwithstanding the provisions of paragraph (a) of this section, no materials previously provided to a purchaser need be provided again unless the purchaser requests, except the disclosure required by paragraph (a)(4) of this section.

(c) Prior to any mandatory exchange of eligible borrower stock, as defined in 615.5260(a)(1), for stock issued under capitalization bylaws required under 615.5220, equityholders shall be provided with the disclosures required by paragraphs (a)(3) and (a)(4) of this section.

(d) Other equities. (1) No stock or participation certificates other than those required to be purchased as a condition of obtaining a loan may be offered for sale except pursuant to a disclosure statement containing all of the information required by 12 CFR Part 620 in the annual report to shareholders as of a date within 135 days of the proposed sale, which disclosure statement must have been reviewed and cleared by the Farm Credit Administration. The most recent annual report to shareholders and the most recent quarterly report filed with the Farm Credit Administration may be incorporated by reference into the disclosure statement in satisfaction of this requirement. In addition, the disclosure statement shall include items in (3) and (4) of paragraph (a) of this section and a discussion of the intended use of the sale proceeds. No materials previously provided to the purchaser need be provided again unless the purchaser requests it, except the disclosure required by paragraph (a)(4) of this section and a discussion of the use of sale proceeds.

(2) At least 45 days prior to the proposed sale of such equities, the institution shall submit the disclosure statement required by paragraph (b)(1) of this section to the Farm Credit Administration for review and clearance.

(3) Within 30 days of the receipt of such disclosure statement and any clarifying information the Farm Credit Administration may request, the Farm Credit Administration shall inform the institution whether the Farm Credit Administration will consider the issuance permanent capital for the purpose of meeting the minimum permanent capital standards established under Subpart H (including interim standards) and shall inform the institution of any required changes or additions to the disclosure materials.

(4) No officer, director, employee, or agent of a System institution shall make any disclosure, through the disclosure statement or otherwise, in connection with the sale of equities that is inaccurate or misleading, or omit to make any statement needed to make other disclosures made by such person not misleading.

(5) The Farm Credit Administration may waive any or all of the disclosure requirements of paragraph (b) of this section when a single investor acquires $100,000 or more of a single class of equity if the sophistication of the purchaser warrants, provided that any certificate that may be issued evidencing such an equity states on its face in boldface type:

The denomination of this equity may not be reduced to less than $100,000 without the prior written approval of the Farm Credit Administration.

(e) The requirements of this section shall not apply to the sale of Farm Credit System institution equities to other Farm Credit System institutions or other financing institutions having a discount or lending relationship with the selling Farm Credit System Institution.

3. Subpart J is revised to read as follows:

Subpart J -- Retirement of Equities

Sec.

615.5260 Retirement of eligible borrower stock.

615.5270 Retirement of other equities.

615.5280 Retirement in event of default.

Subpart J -- Retirement of Equities

615.5260 Retirement of eligible borrower stock.

(a) Definitions. For the purposes of this subpart the following definitions shall apply:

(1) "Eligible borrowers stock" means:

(i) Stock, participation certificates or allocated equities outstanding on January 6, 1988, or purchased as a condition of obtaining a loan prior to the earlier of the date of shareholder approval of capitalization bylaws under section 4.3A of the Act or October 6, 1988; and

(ii) Any stock, participation certificates or allocated equities for which such eligible borrower stock is exchanged in connection with a merger, consolidation, or other reorganization or a transfer of territory. "Eligible borrower stock" does not include equities for which eligible borrower stock is required to be exchanged pursuant to the bylaws adopted under section 4.3A or equities for which eligible borrower stock is voluntarily exchanged except in connection with a merger, consolidation or other reorganization or a transfer of territory.

(2) "Retirement in the ordinary course of business" means:

(i) Retirement upon repayment of a loan or under a retirement or revolvement plan in effect prior to January 6, 1988, and for eligible borrower stock issued after that date, at the time the loan was made;

(ii) Retirement pursuant to 615.5280 and 615.5290; or

(iii) Retirement necessary to accomplish an exchange of eligible borrower stock for a like amount of at-risk stock.

(3) "Par value" means:

(i) In the case of stock, par value;

(ii) In the case of participation certificates and other equities (except equities unable to be retired in connection with a liquidation occurring after January 1, 1983, and before January 1, 1988), face or equivalent value; or

(iii) In the case of participation certificates and allocated surplus subject to retirement under a revolving cycle and retired out or order pursuant to 615.5280 and 615.5290 or otherwise under the Act, par or face value discounted at a rate determined by the institution to reflect the present value of the equity as of the date of such retirement.

(b) When an institution retires eligible borrower stock in the ordinary course of business, such equities shall be retired at par, even if book value is less than par.

(c) When a Farm Credit Bank retires stock for the sole purpose of enabling an association to retire eligible borrower stock that was issued in connection with a long term real estate loan, such stock shall be retired at par even if its book value is less than par.

(d) No eligible borrower stock shall be retired other than in the ordinary course of business without the prior approval of the Farm Credit Administration.

615.5270 Retirement of other equities.

(a) Equities other than eligible borrower stock shall be retired at not more than their book value.

(b) No equities shall be retired, except pursuant to 615.5280 and 615.5290, unless after the retirement the institution would continue to meet the minimum permanent capital standards (including interim standards) established under Subpart H of this Part.
615.5280 Retirement in event of default.

(a) When the debt of a holder of eligible borrower stock issued by a production credit association, Federal land bank association or agricultural credit association is in default, such institution may, but shall not be required to, retire at par eligible borrower stock owned by such borrower on which the institution has a lien, in total or partial liquidation of the debt.

(b) When the debt of a holder of stock, participation certificates or other equities issued by a production credit association, Federal land bank association, or agricultural credit association is in default, such institution may, but shall not be required to, retire at book value not to exceed par all or part of such equities, other than eligible borrower stock as defined in 615.5260(a)(1), owned by such borrower on which the institution has a lien, in total or partial liquidation of the debt.

(c) When the debt of a holder of equities or guaranty fund certificates issued by a bank for cooperatives is in default, the bank for cooperatives may, but shall not be required to, retire all or part of such equities or guaranty fund investments owned by the borrower on which the bank for cooperatives has a lien, in total or partial liquidation of the debt. If such investments qualify as eligible borrower stock, it shall be retired at par, as defined in 615.5260(a)(3). All other investments shall be retired at a rate determined by the institution to reflect its present value on the date of retirement.

(d) When the debt of a holder of the equities of a Farm Credit Bank is in default, the Farm Credit Bank may, but shall not be required to, retire all or part of such equities owned by the borrower on which the Farm Credit Bank has a lien, in total or partial liquidation of the debt. If such equities qualify as eligible borrower stock or are retired solely to permit a Federal land bank association to retire eligible borrower stock under 615.5280(a), they shall be retired at par. All other equities shall be retired at book value not to exceed par.

(e) Any retirements made under this section by a Federal land bank association that is not a direct lender shall be made only upon the specific approval of or in accordance with approval procedures issued by the district Farm Credit Bank.

(f) Prior to making any retirement pursuant to this section, except retirements pursuant to paragraphs (c) and (d) of this section, the institution shall provide the borrower with written notice of the following matters;

(1) A statement that the institution has declared the borrower's loan to be in default;

(2) A statement that the institution will retire all or part of the equities of the borrower in total or partial liquidation of his or her loan;

(3) A description of the effect of the retirement on the relationship of the borrower to the institution;

(4) A statement of the amount of the outstanding debt that will be owed to the institution after the retirement of the borrower's equities; and

(5) The date on which the institution will retire the equities of the borrower.

(g) The notice required by this section shall be provided in person at least 10 days prior to the retirement of any equities of a holder, or by mailing a copy of the notice by first class mail to the last known address of the equity holder at least 13 days prior to the retirement of such person's equities.

(h) The requirements of this section may be satisfied by notices given pursuant to 614.4516, 614.4518, and 614.4519 of Title 12 of the Code of Federal Regulations that contain the information required by this section.

4. Subpart K is revised to read as follows:

Subpart K -- Surplus and Reserves

Sec.

615.5330 Banks for cooperatives.

Subpart K -- Surplus and Reserves

615.5330 Banks for cooperatives.

Each bank for cooperatives shall add to the unallocated surplus account annually an amount not less than 10 percent of net earnings after taxes until such time as the unallocated surplus equals half of the minimum permanent capital requirement established under 615.5205(a) of Subpart H of this part.

615.5350-615.5440 (Subparts L-N) [Removed and Reserved]

5. Subparts L, M, and N are removed and reserved.

Subpart L [Reserved]

Subpart M [Reserved]

Subpart N [Reserved]

* * * * *

Date: October 7, 1988.

David A. Hill,

Secretary, Farm Credit Administration Board.

[FR Doc. 88-23613 Filed 10-12-88; 8:45 am]
BILLING CODE 6705-01-M