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Letters to Regulators

FCS Preferred Stock Proposed Rule

August 3, 2004

Mr. Robert Coleman
Director, Regulation and Policy Division
Office of Policy and Analysis
Farm Credit Administration
1501 Farm Credit Drive
McLean, Virginia 22102-5090

RE: FCS Preferred Stock Proposed Rule - RIN 3052-AC21

Dear Mr. Coleman:

We are sending this letter on behalf of the Independent Community Bankers of America (ICBA)1 and our community bank members. Our comments pertain to the Farm Credit Administration's (FCA) request for comments regarding a proposed rule on preferred stock offered by Farm Credit System (FCS) institutions.

Background: Preferred Stock Proposed Rule

The FCA has asked for responses to a June 4, 2004 proposed rule that would change the regulatory capital treatment of preferred stock issued by FCS institutions. The proposed rule would place restrictions on the retirement of such preferred stock and would require greater board involvement and oversight when retiring stock. In addition, the proposal would seek to improve the current standards of conduct regulations to address insider preferred stock transactions and would require disclosure of senior officer and director preferred stock transactions. Furthermore, the proposed rule would add a provision to control investments by FCS banks and associations in the preferred stock of other FCS institutions.

According to the FCA, it has received an increased number of requests from FCS institutions seeking to issue preferred stock and this has led the agency to identify some policy and safety and soundness issues that need to be addressed. FCA has raised questions about the stability of preferred stock that can be easily redeemed at any time without direct involvement by the institution's board of directors.

ICBA Comments

In light of the recent increase in the number of requests FCA has received from FCS institutions to offer preferred stock, ICBA appreciates FCA's efforts to develop a regulatory framework that clearly stipulates the requirements of FCS institutions that seek to issue such stock. However, we question why FCS should be allowed to offer preferred stock at all unless it is in lieu of allowing System institutions to offer various forms of cash management accounts, which should be deemed illegal by FCA. The Farm Credit Act only authorizes the System to offer a funds held account for the purpose of making payments against future farm loans. FCA is allowing FCS institutions to offer cash management accounts, which basically amount to checking accounts, clearly in contradiction to the Act.

Therefore, if the FCA intends to allow the System to offer preferred stock, such issuances should be in lieu of System entities offering cash management accounts and System preferred stock should at the very least conform to requirements for preferred stock issuances of the commercial banking industry.

The System can already access our nation's capital markets to raise funds for lending. FCS lenders also require borrowers to purchase $1,000 in stock to capitalize their associations. In addition, FCS lenders have made a practice of keeping retained earnings to further capitalize FCS associations. As a result, most FCS entities have an average permanent capital ratio of 12% or higher, so we ask FCA to fully explain why it would be necessary for FCS associations to use preferred stock as yet another means to raise additional capital? We also ask FCA to address whether allowing FCS institutions to issue preferred stock will be in lieu of the System's use of cash management accounts, which are in contradiction with the Farm Credit Act?

As proposed by FCA, due to the short-term nature (one-year) and ability of FCS borrowers to redeem the stock at their request, preferred stock could be used as a mechanism by the FCS to essentially take deposits, which will be a major assault on the ability of banks to access core deposits as a funding source for their customers. We oppose allowing FCS institutions to offer preferred stock in this manner since it will only create unfair competition by a government-sponsored enterprise (GSE) for the deposit base of community banks.

ICBA recommends several changes to the proposed rule should FCA move forward. Rather than having only a one-year maturity for FCS preferred stock, we believe FCA should require the stock to have at least an effective maturity of 5 years. This would better recognize the purpose of preferred stock to provide stable capital of a long-term nature. Otherwise, we would foresee the potential for serious safety and soundness issues occurring for various FCS institutions.

Minimum Maturity of Preferred Stock

The FCA proposes to prohibit the retirement of preferred stock within one year of its issuance. ICBA believes that a stock instrument with such a short maturity or timeframe for retirement would have the same features and characteristics of certificates of deposit (CDs) or money market accounts. We question what the difference between such preferred stock and a one-year CD would be and we ask FCA to explain the rationale for the proposal.

This could lead to FCS institutions engaging in deposit-taking activities, which are not authorized by the Farm Credit Act. As we noted above, there are already many abuses of the Act by System institutions utilizing cash management accounts. If such accounts are allowed to continue and System entities can also offer one-year preferred stock redemption, FCS institutions, in essence, will be transformed into depository institutions that have unique GSE benefits, including an exemption from federal income taxes on real estate loans; exemption from sales taxes due to their status as "federal instrumentalities of the U.S." and several other tax benefits. In fact, one large FCS institution even calls its cash management product a "Money Market Investment Account". FCA needs to stop such blatant abuse of the Act.

The FCA should use this rulemaking to ensure any preferred stock issuances by the FCS are truly a stock issuance with clear and strict guidelines regarding dividends and stock retirement consistent with banking regulations. Such stock should not be a continually redeemable security that only serves as a short-term investment or cash management activity.

Therefore, any preferred stock issued by FCS institutions should have a maturity of at least 5 years and should not be eligible for retirement before 5 years from the date of issuance. This would help address the problem of preferred stock performing too much like a money market account or a CD.

For example, the FDIC's regulations for intermediate-term preferred stock issued by banks requires a minimum maturity of at least 5 years and prohibits the holder of the stock from requesting a redemption prior to the maturity date. Such stock is not eligible for inclusion in core capital (Tier 1), but only supplementary capital (Tier 2). Realistically, the FCS, as a GSE with a specialized, congressionally mandated charge to serve only a higher-risk market of agricultural lending, should be required to conform to even stricter regulations and capital ratios than commercial banks.

In addition, we believe any retirement of stock should be conducted on the basis of the entire class of stock, rather than on an individual basis by request from stockholders. Otherwise, preferred stock retired by request on an individual basis allows it to function as a deposit and it would be marketed as such by the FCS.

Other Legal Requirements

This proposal also raises several questions in terms of other legal requirements that the FCS should have to adhere to if issuing preferred stock. For instance, would the FCS institutions have to reserve funds for short-term preferred stock as commercial banks do for their "deposits"? Would these "deposits" be subject to disclosure under the Truth-In-Savings Act, which commercial banks must adhere to? Would these "deposits" be subject to the Patriot Act requirements as the deposits of commercial banks are? These are all issues that should be addressed by the FCA regarding preferred stock, but are not mentioned in the current proposed rule. We would like to know how the FCA intends to address these additional requirements that should be placed on FCS entities that issue preferred stock.

Permanency of Preferred Stock

ICBA opposes the FCA proposal to discount the amount of preferred stock that is included in an FCS institution's permanent capital ratio as the effective maturity of the stock reaches 5 years and less. Preferred stock should not be included in an institution's permanent capital unless it is perpetual preferred stock that has no maturity and no requirements for future redemption. Also see our comments below on preferred stock as permanent capital.

Dividends

We agree with the proposed requirement that before any dividends can be paid on preferred stock, the board of directors of the FCS institution must first declare a dividend on the class of stock. This, again, helps to address the issue of these stock issuances functioning like deposits rather than investments. This should help to ensure there are no discriminatory practices involved with the payment of dividends only to particular stockholders upon their individual request.

Limitations on Stock Purchases and Ownership

ICBA supports the proposal that no credit can be extended by an FCS institution to a borrower for the purpose of purchasing preferred stock in the institution. However, we question the level of the limitation on ownership of an entity's preferred stock by any one individual set at $2 million or 5% of the outstanding preferred stock. These levels seem excessive, and actually meaningless for limitations placed on individuals. Borrowers already supposedly capitalize the system with $1,000 when they apply for loans.

This provision seems aimed at allowing agribusinesses to invest in the FCS by holding preferred stock. If this is the case, then there should be different classes of stock established, with a much smaller, more meaningful cap for individuals. However, we see no need to allow agribusinesses to invest in the FCS in the first place since the system can access the capital markets for funding. This would also threaten a major deposit source for community banks. Therefore, a $5,000 cap would be appropriate for all borrowers.

FCS Ownership of Preferred Stock in other FCS Entities

While we appreciate the FCA's proposal to require FCA approval of any FCS institutions' purchase of preferred stock in another FCS entity or Farmer Mac, we believe this is contrary to the purpose and scope of FCS activities. We see no reason for FCS institutions to purchase preferred stock in other FCS entities. This could only serve to complicate the regulation of the System by the FCA and lead to difficulties in tracking the investments of individual FCS institutions in other entities. Again, this is unnecessary since the system can raise funds in the capital markets. We urge the FCA to address this issue by preventing any FCS entity from purchasing preferred stock in any other FCS institution or Farmer Mac.

Preferred Stock as Permanent Capital

The Farm Credit Act of 1971, as amended, prohibits FCS entities from including in permanent capital "stock that may be retired by the holder of the stock on repayment of the holder's loan, or otherwise at the option or request of the holder"3. As such, it should be clear to the FCA that Congress did not intend for any stock with a redemption feature available to the holder to be included in the permanent capital of FCS institutions.

In addition, we are concerned with the proposed requirement that any preferred stock with an effective maturity of less than 5 years can make up 25% of a FCS entities' permanent capital. As stated, only perpetual preferred stock should be eligible to be included in an FCS institution's permanent capital. For example, the FDIC allows commercial banks to only include perpetual preferred stock in core capital (Tier 1). The regulation states:

1. Core capital elements (Tier1) consists of:
…noncumulative perpetual preferred stock, which is defined as preferred stock that does not have a maturity date, that cannot be redeemed at the option of the holder, and that has no other provisions that will require future redemption of the issue4.

Therefore, we believe the FCA should limit FCS preferred stock that is counted as permanent capital to only perpetual preferred stock with no provisions that require future redemption. The FCA should seriously consider the limited permanency of redeemable preferred stock with a maturity of less than 5 years. This will help to address the FCA's safety and soundness concerns of FCS entities that are involved in the issuance of preferred stock.

Board Delegation of Stock Retirement

While FCA proposes to limit the delegation to management by the local boards of directors any decisions regarding the retirement of preferred stock, we believe these decisions should rest solely with the FCS institutions' boards of directors. No matter what the financial condition of the entity or how strong its permanent capital ratio, the retirement of preferred stock is a decision best left to the local boards of directors in compliance with FCA's regulations.

This will help to avoid any conflicts of interests that could be present with management and their decisions to retire stock when it may not be completely in the best interests of the institution. Furthermore, if the FCA's regulation requires all decisions regarding preferred stock to be made by local boards of directors, all relevant information would then be recorded and maintained in the minutes of the board meetings. This will ensure at least a minimal level of transparency and accountability regarding preferred stock decisions.

The proposal seeks to prohibit the retirement of limited life preferred stock (5 years or less original maturity) unless the FCS institution has a permanent capital ratio of 8% or greater. Banking regulations require 9% for commercial banks. However, we believe, given the purpose of the FCS to serve a specific market, agricultural lending, and the risks associated with this industry, the retirement of any preferred stock should only be allowed if the entity has a permanent capital ratio of at least 12% or greater. Most FCS entities are currently well above the 8% level, which makes this a rather meaningless provision as FCA has proposed it, so the percentage should be increased to a level that is more in line with the system's current average permanent capital ratio.

Disclosure of Insider Stock Transactions

ICBA supports the proposed disclosure requirements for FCS senior officers and directors that are involved in preferred stock transactions. We agree that information should be reported including the person's name, amount of stock owned, dividend paid, and any purchases or retirements during the reporting period. This information should be made available on the institution's website showing transactions for each quarter and should be published in its annual report, in addition to being available at any time upon request.

This information should be available through Freedom of Information Act (FOIA) requests without restrictions. Proprietary information can easily be excluded from FOIA requests. The complete and timely disclosure of this information is necessary to ensure full transparency, public accountability, and to maintain the financial integrity of the FCS institution.

Stock Registration with the Securities and Exchange Commission

We also strongly urge the FCA to require any issuances of FCS preferred stock to be registered with the Securities and Exchange Commission (SEC). Publicly traded entities, including banking institutions, must register their securities with the SEC and the same should be required of FCS associations offering preferred stock. Registration is necessary to ensure appropriate accountability and oversight, and not requiring this degree of transparency would be wholly inappropriate for the FCA to allow as the System regulator.

Conclusion

We strongly urge the FCA to consider our concerns with this proposed regulation for the reasons cited. If FCA proceeds with final rulemaking on preferred stock offerings, we recommend that the FCA make the appropriate changes to address the concerns we have raised in regard to FCS preferred stock and require FCS entities to discontinue their various cash management accounts, which we again note are inconsistent with the Act.

The final rule should ensure preferred stock can only be redeemed at least 5 years from the original date of issuance rather than the 1-year period as proposed and then only by class, not on an individual basis as requested by stockholders. And, only perpetual preferred stock should be eligible to be counted as permanent capital.

We urge the FCA to adopt our recommendations to ensure preferred stock offerings by FCS institutions are not used as quasi deposit-taking mechanisms, which would be outside the scope and authorization of FCS activities, and would lead to unfair competition for community banks' deposit base. We also point out that the FCA's proposed regulation is inconsistent with the treatment of preferred stock by bank regulators and the FCS, as a GSE, should have much more stringent criteria, especially when there is a risk of displacing the deposit base of community banks. Threatening the deposit base of community banks hurts rural America, which is also inconsistent with the aims of the Farm Credit Act.

We appreciate the opportunity to provide our comments on this proposed rule. If you have any questions or need any further information regarding this comment letter, please feel free to contact Mark Scanlan, director, Office of Agriculture and Rural Policy or Reece Langley, deputy director, Office of Agriculture and Rural Policy at 202-659-8111.

Sincerely,

Camden R. Fine
President and CEO

1 The Independent Community Bankers of America represents the largest constituency of community banks of all sizes and charter types in the nation, and is dedicated exclusively to protecting the interests of the community banking industry. ICBA aggregates the power of its members to provide a voice for community banking interests in Washington, resources to enhance community bank education and marketability, and profitability options to help community banks compete in an ever-changing marketplace. For more information, visit ICBA's website at www.icba.org.

2 Federal Deposit Insurance Corporation regulation. 12 CFR Chapter III, Part 325, Appendix A. Statement of Policy on Risk-Based Capital.

3 Farm Credit Act. 12 USC 2154a(a)(D)(i).

4 Federal Deposit Insurance Corporation regulations. 12 CFR Chapter III, Part 325, Appendix A. Statement of Policy on Risk-Based Capital.






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