[Code of Federal Regulations]
[Title 12, Volume 3]
[Revised as of January 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 12CFR221.124]

[Page 53-55]
 
                       TITLE 12--BANKS AND BANKING
 
                   CHAPTER II--FEDERAL RESERVE SYSTEM
 
PART 221--CREDIT BY BANKS AND PERSONS OTHER THAN BROKERS OR DEALERS FOR THE PURPOSE OF PURCHASING OR CARRYING MARGIN STOCK (REGULATION U)--Table of Contents
 
Sec. 221.124  Purchase of debt securities to finance corporate takeovers.

    (a) Petitions have been filed with the Board raising questions as to 
whether the margin requirements in this part apply to two types of 
corporate acquisitions in which debt securities are issued to finance 
the acquisition of margin stock of a target company.
    (b) In the first situation, the acquiring company, Company A, 
controls a shell corporation that would make a tender offer for the 
stock of Company B, which is margin stock (as defined in Sec. 221.2). 
The shell corporation has virtually no operations, has no significant 
business function other than to acquire and hold the stock of Company B, 
and has substantially no assets other than the margin stock to be 
acquired. To finance the tender offer, the shell corporation would issue 
debt securities which, by their terms, would be unsecured. If the tender 
offer is successful, the shell corporation would seek to merge with 
Company B. However, the tender offer seeks to acquire fewer shares of 
Company B than is necessary under state law to effect a short form 
merger with Company B, which could be consummated without the approval 
of shareholders or the board of directors of Company B.
    (c) The purchase of the debt securities issued by the shell 
corporation to finance the acquisition clearly involves purpose credit 
(as defined in Sec. 221.2). In addition, such debt securities would be 
purchased only by sophisticated investors in very large minimum 
denominations, so that the purchasers may be lenders for purposes of 
this part. See Sec. 221.3(b). Since the debt securities contain no 
direct security agreement involving the margin stock, applicability of 
the lending restrictions of this part turns on whether the arrangement 
constitutes an extension of credit that is secured indirectly by margin 
stock.
    (d) As the Board has recognized, indirect security can encompass a 
wide variety of arrangements between lenders and borrowers with respect 
to margin stock collateral that serve to protect the lenders' interest 
in assuring that a credit is repaid where the lenders do not have a 
conventional direct security interest in the collateral. See 
Sec. 221.124. However, credit is not ``indirectly secured'' by margin 
stock if the lender in good faith has not relied on the margin stock as 
collateral extending or maintaining credit. See Sec. 221.2.
    (e) The Board is of the view that, in the situation described in 
paragraph (b) of this section, the debt securities would be presumed to 
be indirectly secured by the margin stock to be acquired by the shell 
acquisition vehicle. The staff has previously expressed the view that 
nominally unsecured credit extended to an investment company, a

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substantial portion of whose assets consist of margin stock, is 
indirectly secured by the margin stock. See Federal Reserve Regulatory 
Service 5-917.12. (See 12 CFR 261.10(f) for information on how to obtain 
Board publications.) This opinion notes that the investment company has 
substantially no assets other than margin stock to support indebtedness 
and thus credit could not be extended to such a company in good faith 
without reliance on the margin stock as collateral.
    (f) The Board believes that this rationale applies to the debt 
securities issued by the shell corporation described in paragraph (b) of 
this section. At the time the debt securities are issued, the shell 
corporation has substantially no assets to support the credit other than 
the margin stock that it has acquired or intends to acquire and has no 
significant business function other than to hold the stock of the target 
company in order to facilitate the acquisition. Moreover, it is possible 
that the shell may hold the margin stock for a significant and 
indefinite period of time, if defensive measures by the target prevent 
consummation of the acquisition. Because of the difficulty in predicting 
the outcome of a contested takeover at the time that credit is committed 
to the shell corporation, the Board believes that the purchasers of the 
debt securities could not, in good faith, lend without reliance on the 
margin stock as collateral. The presumption that the debt securities are 
indirectly secured by margin stock would not apply if there is specific 
evidence that lenders could in good faith rely on assets other than 
margin stock as collateral, such as a guaranty of the debt securities by 
the shell corporation's parent company or another company that has 
substantial non-margin stock assets or cash flow. This presumption would 
also not apply if there is a merger agreement between the acquiring and 
target companies entered into at the time the commitment is made to 
purchase the debt securities or in any event before loan funds are 
advanced. In addition, the presumption would not apply if the obligation 
of the purchasers of the debt securities to advance funds to the shell 
corporation is contingent on the shell's acquisition of the minimum 
number of shares necessary under applicable state law to effect a merger 
between the acquiring and target companies without the approval of 
either the shareholders or directors of the target company. In these two 
situations where the merger will take place promptly, the Board believes 
the lenders could reasonably be presumed to be relying on the assets of 
the target for repayment.
    (g) In addition, the Board is of the view that the debt securities 
described in paragraph (b) of this section are indirectly secured by 
margin stock because there is a practical restriction on the ability of 
the shell corporation to dispose of the margin stock of the target 
company. Indirectly secured is defined in Sec. 221.2 to include any 
arrangement under which the customer's right or ability to sell, pledge, 
or otherwise dispose of margin stock owned by the customer is in any way 
restricted while the credit remains outstanding. The purchasers of the 
debt securities issued by a shell corporation to finance a takeover 
attempt clearly understand that the shell corporation intends to acquire 
the margin stock of the target company in order to effect the 
acquisition of that company. This understanding represents a practical 
restriction on the ability of the shell corporation to dispose of the 
target's margin stock and to acquire other assets with the proceeds of 
the credit.
    (h) In the second situation, Company C, an operating company with 
substantial assets or cash flow, seeks to acquire Company D, which is 
significantly larger than Company C. Company C establishes a shell 
corporation that together with Company C makes a tender offer for the 
shares of Company D, which is margin stock. To finance the tender offer, 
the shell corporation would obtain a bank loan that complies with the 
margin lending restrictions of this part and Company C would issue debt 
securities that would not be directly secured by any margin stock. The 
Board is of the opinion that these debt securities should not be 
presumed to be indirectly secured by the margin stock of Company D, 
since, as an operating business, Company C has substantial assets or 
cash flow without regard to the margin stock of Company

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D. Any presumption would not be appropriate because the purchasers of 
the debt securities may be relying on assets other than margin stock of 
Company D for repayment of the credit.