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EXAMINING ISSUANCE
Comptroller of the Currency
Administrator of National Banks
Type:  Examining Circular
Subject:  Highly Leveraged Transactions

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

BACKGROUND AND PURPOSE

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

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

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

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

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

EXAMINATION GUIDELINES

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

o Determine the extent and types of involvement in HLTs;

o Assess the adequacy of policy and controls;

o Assess the adequacy of MIS and other reporting systems;

o Determine the level of HLT exposure;

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

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

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

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

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

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

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

A.	GENERAL POLICY STATEMENT

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

o The purpose and use of such financing;

o Permissible lending and investment activities;

o Identification of industries suited for such financing;

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

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

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

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

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

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

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

B.	LENDING POLICY

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

The lending policy should include:

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

o MIS type and reporting frequency;

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

o Pricing considerations;

o Legal review requirements;

o Requirements for review by asset sales and distribution personnel;

o Requirements for interest rate protection; and

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

C. PORTFOLIO ANALYSIS AND MIS

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

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

o Concentration by industry and type of financing, e.g. leveraged buyout,
  recapitalization, cashout, etc.;

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

o Information by originator;

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

o Portfolio aging and performance relative to expectations; and

o Listing of all refinancing and restructured transactions.

D.	DISTRIBUTION AND PARTICIPATIONS

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

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

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

o Credit standards and approval process for counterparty risk;

o An approved customer list;

o Sell-down guidelines and disclosure requirements;

o Repurchase guidelines;

o MIS and other reporting requirements;

o Controls on incentive or commission programs; and

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

E.	INTERNAL REVIEWS

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

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

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

o Testing and reaffirmation of underwriting criteria;

o Testing for compliance with policy and procedures;

o Testing of individual risk ratings;

o Assessment of aggregate risk rating levels and trends;

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

o Assessment of industry concentrations; and

o Identification of emerging trends and potential problems.

F.	EQUITY INVESTMENTS

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

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

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

These policies should include:

o Aggregate and individual investment limits;

o Designated booking units;

o MIS and other reporting requirements;

o Investment criteria and documentation for investment decisions;

o Periodic valuation;

o An internal risk rating system;

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

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

G.	MEZZANINE FINANCING

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

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

o Limits for both aggregate volume and individual transactions;

o Designated booking units;

o Credit approval and reporting processes;

o MIS and other reporting requirements;

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

o Procedures for legal review of HLT transactions.

H.	RESERVES

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

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

I.	LEGAL REVIEWS AND POTENTIAL CONFLICTS OF INTEREST

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

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

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

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

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

Originating Office:

Multinational Banking Department
Washington, D.C. 20219
(202) 874-5170

Dean S. Marriott
Senior Deputy Comptroller
for Bank Supervision Operations

Date:  December 14, 1988