17766 Federal Register / Vol. 78, No. 56 / Friday, March 22, 2013 / Notices

§ 1016.5(a)—Disclosure (institution)— third parties with respect to which the DEPARTMENT OF THE TREASURY Annual privacy notice to customers consumer wishes to opt out. requirement—A national bank or §§ 1016.7(h) and 1016(i)—Reporting Office of the Comptroller of the Federal savings association must (consumer)—Consumers may exercise Currency provide a clear and conspicuous notice continuing right to opt out—Consumer [Docket ID OCC–2011–0028] to customers that accurately reflects its may opt out at any time—A consumer privacy policies and practices not less may exercise the right to opt out at any FEDERAL RESERVE SYSTEM than annually during the continuation time. A consumer’s direction to opt out [OP–1438] of the customer relationship. is effective until the consumer revokes § 1016.8—Disclosure (institution)— it in writing or, if the consumer agrees, FEDERAL DEPOSIT INSURANCE Revised privacy notices—If a national electronically. When a customer CORPORATION bank or Federal savings association relationship terminates, the customer’s wishes to disclose information in a way opt out direction continues to apply. Interagency Guidance on Leveraged that is inconsistent with the notices Type of Review: Extension of a Lending previously given to a consumer, the currently approved collection. national bank or Federal savings AGENCY: The Office of the Comptroller Affected Public: Businesses or other of the Currency (OCC), Department of association must provide consumers for-profit; individuals. with a clear and conspicuous revised the Treasury; Board of Governors of the Estimated Annual Number of notice of the national bank’s or Federal Federal Reserve System (Board); and the Institution Respondents: Initial Notice, savings association’s policies and Federal Deposit Insurance Corporation 3; Annual Notice and Change in Terms, procedures and a new opt out notice. (FDIC). 1,793; Opt-out Notice, 897. § 1016.7(a)—Disclosure (institution)— ACTION: Final guidance. Form of opt out notice to consumers; opt Estimated Average Time per Response per Institution: Initial Notice, 80 hours; SUMMARY: The OCC, Board, and the out methods—Form of opt out notice— FDIC (collectively, the ‘‘agencies’’) are If a national bank or Federal savings Annual Notice and Change in Terms, 8 hours; Opt-out Notice, 8 hours. issuing final guidance on leveraged association is required to provide an lending. This guidance outlines for opt-out notice under § 1016.10(a), it Estimated Subtotal Annual Burden Hours for Institutions: 21,760 hours. agency-supervised institutions high- must provide a clear and conspicuous level principles related to safe-and- Estimated Annual Number of notice to each of its consumers that sound leveraged lending activities, Consumer Respondents: 2,526,802. accurately explains the right to opt out including underwriting considerations, under that section. The notice must Estimated Average Time per assessing and documenting enterprise state: Consumer Response: 0.25 hours. • value, risk management expectations for That the national bank or Federal Estimated Subtotal Annual Burden credits awaiting distribution, stress- savings association discloses or reserves Hours for Consumers: 631,701 hours. testing expectations, pipeline portfolio the right to disclose nonpublic personal Estimated Total Annual Burden management, and risk management information about its consumer to a Hours: 653,461 hours. expectations for exposures held by the nonaffiliated third party; • Comments: The OCC issued a 60-day institution. This guidance applies to all That the consumer has the right to Federal Register notice on January 14, financial institutions supervised by the opt out of that disclosure; and • 2013. 78 FR 2720. No comments were OCC, Board, and FDIC that engage in A reasonable means by which the received. Comments continue to be leveraged lending activities. The consumer may exercise the opt out invited on: number of community banks with right. substantial involvement in leveraged A national bank or Federal savings (a) Whether the collection of lending is small; therefore, the agencies association provides a reasonable means information is necessary for the proper generally expect community banks to be to exercise an opt out right if it: performance of the functions of the • Designates check-off boxes on the OCC, including whether the information largely unaffected by this guidance. relevant forms with the opt out notice; has practical utility; DATES: This guidance is effective on • Includes a reply form with the opt (b) The accuracy of the OCC’s March 22, 2013. The compliance date out notice; estimate of the information collection for this guidance is May 21, 2013. • Provides electronic means to opt burden; FOR FURTHER INFORMATION CONTACT: out; or (c) Ways to enhance the quality, OCC: Louise A. Francis, Commercial • Provides a toll-free number to opt utility, and clarity of the information to Credit Technical Expert, (202) 649– out. be collected; 6670, [email protected]; or §§ 1016.10(a)(2) and 1016(c)— (d) Ways to minimize the burden of Kevin Korzeniewski, Attorney, Consumers must take affirmative the collection on respondents, including Legislative and Regulatory Activities actions to exercise their rights to prevent through the use of automated collection Division, (202) 649–5490, 400 7th Street financial institutions from sharing their techniques or other forms of information SW., MS 7W–2, Washington, DC 20219. information with nonaffiliated parties— technology; and Board: Carmen Holly, Supervisory Financial Analyst, Policy Section, (202) • (e) Estimates of capital or start-up Opt out—Consumers may direct costs and costs of operation, 973–6122, [email protected]; that the national bank or Federal savings maintenance, and purchase of services Robert Cote, Senior Supervisory association not disclose nonpublic to provide information. Financial Analyst, Risk Section, (202) personal information about them to a 452–3354, [email protected]; or nonaffiliated third party, other than Dated: March 18, 2013. Benjamin W. McDonough, Senior permitted by §§ 1016.13–1016.15. Michele Meyer, Counsel, Legal Division, (202) 452– • Partial opt out—Consumer also may Assistant Director, Legislative and Regulatory 2036, [email protected]; exercise partial opt out rights by Activities Division. Board of Governors of the Federal selecting certain nonpublic personal [FR Doc. 2013–06585 Filed 3–21–13; 8:45 am] Reserve System, 20th and C Streets information or certain nonaffiliated BILLING CODE 4810–33–P NW., Washington, DC 20551.

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FDIC: Thomas F. Lyons, Senior pipelines. Financial institutions A. Terminology Examination Specialist, Division of Risk unprepared for such stressful events and One purpose of the final guidance is Management Supervision, (202) 898– circumstances can suffer acute threats to to update and replace guidance issued 6850, [email protected]; or Gregory S. their financial condition and viability. in April 2001, titled ‘‘Interagency Feder, Counsel, Legal Division, (202) This final guidance is intended to be Guidance on Leveraged Financing’’ 898–8724, [email protected]; 550 17th consistent with sound industry (2001 guidance). The 2001 guidance Street NW., Washington, DC 20429. practices and to expand on recent covered broad risk management issues 3 SUPPLEMENTARY INFORMATION: interagency issuances on stress-testing. associated with leveraged finance I. Background II. Discussion of Public Comments activities. This final guidance focuses on leveraged lending activities On March 30, 2012, the agencies Received conducted by financial institutions. requested public comment on the joint The agencies received 16 comment Therefore, to promote clarity and Proposed Guidance on Leveraged letters on the proposed guidance. consistency, the agencies have used the Lending (the proposed guidance) with Comments were submitted by bank term ‘‘leveraged lending’’ in the final the comment period closing on June 8, holding companies, commercial banks, guidance in place of all references to 2012.1 The agencies have reviewed the financial trade associations, financial ‘‘leveraged finance’’ that appeared in the public comments, and are now issuing advisory firms, and individuals. proposed guidance. This change is final guidance (final guidance) that Generally, most comments expressed intended to focus the applicability and includes certain modifications support for the proposed guidance; scope of the final guidance on specific discussed in more detail in section II of however, several comments types of leveraged lending transactions; this SUPPLEMENTARY INFORMATION. recommended changes to and those leveraged loans originated by As addressed in the final guidance, clarification of certain provisions in the financial institutions. the agencies expect financial proposed guidance. institutions to properly evaluate and The comments highlighted the B. Scope monitor underwritten credit risks in following as primary issues of concern leveraged loans, to understand the effect Several comment letters expressed or interest or areas that could benefit concern about the potential effect of the of changes in borrowers’ enterprise from further explanation: values on credit portfolio quality, and to • proposed guidance on community banks The potential effect of the proposed and mid-sized institutions. The assess the sensitivity of future credit guidance on community and mid-sized losses to these changes in enterprise comments stressed that small financial financial institutions; institutions also can have exposure to values.2 Further, in underwriting such • Definition of leveraged lending; leveraged loans. All of the comments credits, financial institutions should • Proposed exclusions for ‘‘fallen expressed concern that the definition of ensure borrowers are able to repay angels’’ and asset-based loans, and leveraged lending used in the proposed credits when due, and that borrowers investment grade borrowers; have sustainable capital structures, • Reporting requirements of deal guidance would encompass a significant including bank borrowings and other sponsors; number of portfolio loans originated by debt, to support their continued • Proposed alternatives to the de- financial institutions, particularly small operations through economic cycles. levering expectations; and mid-sized banks, including, but not Financial institutions also should be • Effect of covenant-lite and payment- limited to, traditional asset-based able to demonstrate they understand the in-kind (PIK)-toggle loan structures; lending portfolios. One comment risks and the potential impact of • Methods used to determine expressed concern that the guidance stressful events and circumstances on enterprise value; could be misinterpreted to require borrowers’ financial condition. Recent • Potential overall management community banks to document and bear financial crises underscore the need for information systems (MIS) burden the burden of proof as to why certain financial institutions to employ sound presented by the proposed guidance; transactions are not considered underwriting, to ensure the risks in and leveraged lending. Another comment leveraged lending activities are • Fiduciary responsibility of a noted that community banks with an appropriately incorporated in the financial institution for loans that it insignificant amount of leveraged allowance for loan and lease losses and originates. lending should not have to follow the capital adequacy analyses, monitor the In response to these comments, the same risk management framework as sustainability of their borrowers’ capital agencies have clarified and modified financial institutions with significant structures, and incorporate stress-testing certain aspects of the guidance as amounts of leveraged lending, as into their risk management of leveraged discussed in the following section of defined in the proposed guidance. Some loan portfolios and distribution this Supplemental Information. comments suggested that the proposed guidance should exclude financial 1 See 77 FR 19417 ‘‘Proposed Guidance on 3 See interagency guidance ‘‘Supervisory institutions under a certain asset or Leveraged Lending’’ dated March 30, 2012 at Guidance on Stress-Testing for Banking capital size, or exclude transactions https://www.federalregister.gov/articles/2012/03/ Organizations With More Than $10 Billion in Total under a certain dollar threshold. 30/2012-7620/proposed-guidance-on-leveraged- Consolidated Assets,’’ Final Supervisory Guidance, lending. 77 FR 29458 (May 17, 2012), at http://www.gpo.gov/ In response to these comments, the 2 For purposes of this final guidance, the term fdsys/pkg/FR-2012-05-17/html/2012-11989.htm, agencies have decided to apply the final ‘‘financial institution’’ or ‘‘institution’’ includes and the joint ‘‘Statement to Clarify Supervisory guidance to all financial institutions national banks, federal savings associations, and Expectations for Stress-Testing by Community that originate or participate in leveraged federal branches and agencies supervised by the Banks,’’ May 14, 2012, by the OCC at http:// OCC; state member banks, bank holding companies, www.occ.gov/news-issuances/news-releases/2012/ lending transactions. However, the savings and loan holding companies, and all other nr-ia-2012-76a.pdf; the Federal Reserve at agencies agree with comments that a institutions for which the Federal Reserve is the www.federalreserve.gov/newsevents/press/bcreg/ financial institution that originates a primary federal supervisor; and state nonmember bcreg20120514b1.pdf; and the FDIC at http:// small number of less complex leveraged banks, foreign banks having an insured branch, www.fdic.gov/news/news/press/2012/pr12054a.pdf. state savings associations, and all other institutions See also FDIC Final Rule, Annual Stress Test, 77 FR loans should not be expected to have for which the FDIC is the primary federal 62417 (Oct. 15, 2012) (to be codified at 12 CFR part policies and procedures commensurate supervisor. 325, subpart C). with those of a larger financial

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institution with a more complex measure of leverage presented in the in the borrower’s financial condition. leveraged loan origination business. proposed guidance definition. Other The comment suggested that the Therefore, the final guidance addresses comments viewed the ratio as a ‘‘bright inclusion of these loans in the definition mainly the latter type of leveraged line’’ and suggested that financial would skew reporting and tracking of lending. However, any financial institutions should develop their own the portfolio, duplicate monitoring institution that participates in rather definition and leverage measure based activities, and increase costs without than originates leveraged lending on an institution’s business lines. The any benefit to financial institutions or to transactions should follow applicable agencies agree that each financial the regulators. The agencies agree that supervisory guidance regarding institution should establish its metrics ‘‘fallen angels’’ should not be included purchased participations. To clarify the for defining leveraged loans and include as leveraged lending transactions, but supervisory expectations for these types those indicators in its credit policies. should be captured within the financial of loans, the agencies have incorporated However, the EBITDA-based leverage institution’s broader risk management the section on ‘‘Participations measure presented in the proposed framework. Therefore, the agencies have Purchased’’ from the 2001 guidance into guidance represented the supervisory stated in the final guidance that a loan the final guidance. measure that may be used as an should be designated as leveraged only Although the agencies elected to important factor to be considered in at the time of origination, modification, adopt a definition of leveraged lending defining leveraged loans based on each extension, or refinance. that encompasses all business lines, the institution’s credit products and One comment suggested that the agencies do not intend for this guidance characteristics. The agencies believe sponsor evaluation standards in the to apply to small portfolio commercial that having a consistent definition for proposed guidance are administratively and industrial loans, or traditional asset- supervisory purposes will help to burdensome and that financial based lending loans. The agencies have ensure a consistent application of the assessments of deal sponsors by lenders added language to the final guidance to guidance. Accordingly, the agencies are should be limited to those sponsors that clarify these concerns. retaining this definition from the provide a financial guaranty. The C. Definition proposed guidance in the final agencies agree that the ability to obtain guidance. The agencies received five comments financial reports on sponsors may be regarding the proposed definition of a D. Information and Reporting limited in the absence of a formal guaranty. Accordingly, the final leveraged lending transaction. A The agencies received a number of number of comments expressed concern comments about the discussion in guidance removes the statement that an over a perceived ‘‘bright line’’ approach portions of the proposed guidance on institution generally should develop to defining leveraged loans and management information systems (MIS) guidelines for evaluating deal sponsors proposed that institutions should be that financial institutions should and instead focuses on deal sponsors able to set their own definitions based implement. Comments stated it would that are relied on as a secondary source on the characteristics of their portfolios. be burdensome for small financial of repayment. In those instances, the The agencies agree that various institutions to implement the same final guidance notes that a financial industries have a range of acceptable reporting mechanisms as large financial institution should document the leverage levels and that financial institutions. Another comment sponsor’s willingness and ability to institutions should do their own suggested that smaller as well as mid- support the credit. analysis to define leveraged lending. sized institutions should discuss the Some comments also suggested The proposed guidance addressed this risks with their regulators to implement exclusions for both asset-based loans issue by providing common definitions appropriate procedures. and ‘‘investment-grade’’ borrowers. As of leveraged lending and directing an To clarify supervisory expectations stated previously, the agencies institution to define leveraged lending for MIS requirements, the final guidance acknowledge that traditional asset-based in its internal policies. The proposed notes that information and reporting lending is a distinct product line and is guidance also indicated that numerous should be tailored to the size and scope not included in the definition of a definitions of leveraged lending exist of each financial institution’s leveraged leveraged loan unless the loan is part of throughout the financial services lending activities. The agencies would the entire debt structure of a leveraged industry. However, the proposed expect a global, complex financial obligor; therefore, the agencies have guidance stated that institutions’ institution with significant origination clarified this point in the final guidance. policies should include criteria to volumes or exposures to leveraged In terms of a borrower’s define leveraged lending in a manner lending to have more complex MIS than creditworthiness, the agencies do not sufficiently detailed to ensure consistent a community bank with only a few believe it would be appropriate to application across all business lines and exposures. Moreover, the final guidance exclude high-quality borrowers from the that are appropriate to the institution. notes that each institution should guidance. Prudent portfolio Therefore, the agencies believe the consider appropriate, cost-effective management of leveraged loans, which definition of leveraged lending measures for monitoring leveraged is a goal of this guidance, covers all described in the proposed guidance was lending given the size and scope of that loans, including those made to the most appropriate, and have retained that institution’s leveraged lending creditworthy borrowers. Importantly, definition in the final guidance. activities. the agencies strongly support the efforts In addition, the agencies received of financial institutions to make loans comments on using earnings before E. Additional Comments available to creditworthy borrowers, interest, taxes, depreciation, and One comment requested that the particularly in small and mid-sized amortization (EBITDA) as a measure to definition of leveraged lending be institutions that extend prudent define leverage. Some comments modified so as not to include ‘‘fallen commercial and industrial loans. All expressed concern that small banks angels.’’ These are loans that do not loans and borrowers except those focus on the balance sheet measure of meet the definition of leverage loans at excluded in the final guidance will be leverage (total debt to tangible net origination, but migrate into the subject to the definitions as outlined in worth) rather than the cash flow definition at a later date due to changes the guidance.

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The agencies also received comments common practices in the industry. information under the PRA. These concerning the ability of borrowers to These methods, if conducted properly, aspects are the provisions that state that repay 50 percent of the total debt produce reliable results. Accordingly, a financial institution should have (i) exposure over a five-to-seven year the final guidance does not require that Underwriting policies for leveraged period. Some comments viewed this an evaluation be conducted by a lending, including stress-testing measure as a restrictive ‘‘bright line’’ business appraiser in determining procedures for leveraged credits; (ii) risk while others proposed alternatives. enterprise value. The agencies’ management policies, including stress- The measure in the proposed expectation is that a financial testing procedures for pipeline guidance was meant as a general guide institution’s internal policies should exposures; and, (iii) policies and to reflect that institutions should address the source and method of any procedures for incorporating the results establish, in their policies, expectations enterprise value estimate. of leveraged credit and pipeline stress and measures for reducing leverage over The agencies received four comments tests into the firm’s overall stress-testing a reasonable period of time. The final regarding the burden imposed by the framework. The frequency of guidance retains the expectation of proposed guidance, stating that information collection is estimated to be reasonable de-levering, and the agencies implementation will add to the high annual. have revised the Underwriting costs that financial institutions already Respondents are financial institutions Standards section of the final guidance face. One comment noted there was no with leveraged lending activities as to state that institutions should consider cost benefit analysis provided with the defined in the guidance. reasonable de-levering abilities of proposed guidance. To address these Report Title: Guidance on Leveraged borrowers, such as whether base case concerns, the final guidance emphasizes Lending. cash flow projections show the ability to that an institution needs to have sound Frequency of Response: Annual. fully amortize senior secured debt or risk management policies and Affected Public: Financial institutions repay a significant portion of total debt procedures commensurate with its with leveraged lending. over the medium term. In addition, the origination activity in and exposures to OCC: agencies have revised the Risk Rating leveraged lending. Moreover, the final OMB Control Number: To be assigned Leveraged Loans section of the final guidance notes that a financial by OMB. guidance to include the measure as an institution’s risk management Estimated number of respondents: 25. example, stating that in the context of framework for leveraged lending should Estimated average time per risk rating of leveraged loans, be consistent with the institution’s risk respondent: 1,350.4 hours to build; supervisors commonly assume that the appetite, and complexity of exposures. 1,705.6 hours for ongoing use. ability to fully amortize senior secured The agencies believe the Estimated total annual burden: 33,760 debt or the ability to repay at least 50 implementation of any additional hours to build; 42,640 hours for ongoing percent of total debt over a five-to-seven systems or processes needed to promote use. year period provides evidence of safe-and-sound leveraged lending Board: adequate repayment capacity. should be considered a component of an Agency information collection One comment referred to covenant- institution’s overall credit risk number: FR 4203. lite and PIK-toggle loan structures, and management program. OMB Control Number: To be assigned recommended that the agencies impose One comment noted that financial by OMB. tighter controls around loans with such institutions in a credit transaction do Estimated number of respondents: 41. features. The agencies believe these not have fiduciary responsibilities to Estimated average time per types of structures may have a place in loan participants when underwriting respondent: 1,064.4 hours to build; the overall leveraged lending product and syndicating leveraged loans. The 754.4 hours for ongoing use. set; however, the agencies recognize the agencies agree and have not included a Estimated total annual burden: 43,640 additional risk in these structures. reference to fiduciary responsibility in hours to build; 30,930 hours for ongoing Accordingly, although the final the final guidance. use. guidance does not have a different FDIC: treatment for such arrangements, the III. Administrative Law Matters OMB Control Number: To be assigned agencies will closely review such loans by OMB. A. Paperwork Reduction Act Analysis as part of the overall credit evaluation Estimated number of respondents: 9. of an institution. In accordance with the Paperwork Estimated average time per One comment suggested that the Reduction Act (PRA) of 1995 (44 U.S.C. respondent: 986.7 hours to build; 529.3 agencies impose more conservative 3506; 5 CFR part 1320, Appendix A.1), hours for ongoing use. guidelines for determining enterprise the agencies reviewed the final Estimated total annual burden: 8,880 value. The comment recommended that guidance. The agencies may not conduct hours to build; 4,764 hours for ongoing the agencies require financial or sponsor, and an organization is not use. institutions to use business appraisers required to respond to, an information The estimated time per respondent is and to follow Internal Revenue Service collection unless the information an average that varies by agency because (IRS) appraisal guidelines when the collection displays a currently valid of differences in the composition of the institution is estimating the enterprise Office of Management and Budget financial institutions under each value of a firm. The intent of the (OMB) control number. The OCC and agency’s supervision (for example, size agencies is not to impose real property FDIC have submitted this collection to distribution of institutions) and volume appraisal and valuation standards to OMB for review and approval under 44 of leveraged lending activities. enterprise valuation methods or to U.S.C. 3506 and 5 CFR part 320. The The agencies received two comments require a formal business appraisal for Board reviewed the final guidance in response to the information all loans relying on enterprise value as under the authority delegated to it by collection requirements under the PRA. a source of repayment. The goal of the OMB. While this final guidance is not Both comments mentioned how final guidance is to clarify those being adopted as a rule, the agencies substantially burdensome the guidance methods considered credible for have determined that certain aspects of will be to implement. The agencies determining enterprise value based on the guidance constitute collections of recognize that the amount of time

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required of any institution to comply personally inspect and photocopy in sections I and II of this with the guidance may be higher or comments at the OCC, 400 7th Street Supplementary Information, the lower than the estimates, but believe SW., Washington, DC 20219. For agencies are issuing the guidance to that the numbers stated are reasonable security reasons, the OCC requires that emphasize the importance of properly averages. visitors make an appointment to inspect underwriting leveraged lending One comment also noted the absence comments. You may do so by calling transactions and incorporating those of a cost-benefit analysis and questioned (202) 649–6700. Upon arrival, visitors exposures into stress and capital tests whether the additional information will be required to present valid for institutions with significant systems required undermines the utility government-issued photo identification exposures to these credits. of the information collection. In and to submit to security screening in The agencies received comments response to the general comments about order to inspect and photocopy about the potential burden of this burden, the agencies have made various comments. guidance on small banking modifications to the proposed guidance, All comments received, including organizations. The final guidance is including clarifying the application of attachments and other supporting intended for banking organizations the guidance to community banks and materials, are part of the public record supervised by the agencies with other smaller institutions that are and subject to public disclosure. Do not substantial exposures to leveraged involved in leveraged lending. In the enclose any information in your lending activities, including national SUPPLEMENTARY INFORMATION section, the comment or supporting materials that banks, federal savings associations, state agencies also highlighted their you consider confidential or nonmember banks, state member banks, expectations that MIS and other inappropriate for public disclosure. bank holding companies, and U.S. reporting activities would be tailored to Additionally, please send a copy of branches and agencies of foreign the size and the scope of an institution’s your comments by mail to: OCC Desk banking organizations. Given the leveraged lending activities. In addition, Officer, 1557–NEW, U.S. Office of average dollar size of leveraged lending the implementation of any new systems Management and Budget, 725 17th transactions, most of which exceed $50 would be part of an institution’s overall Street NW., #10235, Washington, DC million, and the agencies’ observations credit risk management program. These 20503, or by email to: oira that leveraged loans tend to be held comments are discussed in more detail [email protected]. primarily by very large or global in the general comment summary in FDIC: Interested parties are invited to financial institutions, the vast majority Section II of the SUPPLEMENTARY submit written comments. All of smaller institutions should not be INFORMATION. comments should refer to the name of affected by this guidance as they have Comments continue to be invited on: the collection, ‘‘Guidance on Leveraged limited exposure to leveraged credits. (a) Whether the collection of Lending.’’ Comments may be submitted information is necessary for the proper by any of the following methods: Interagency Guidance on Leveraged performance of the Federal banking • http://www.FDIC.gov/regulations/ Lending agencies’ functions, including whether laws/federal/propose.html. the information has practical utility; • Email: [email protected]. The text of the guidance is as follows: • (b) The accuracy of the estimates of Mail: Gary Kuiper (202) 898–3877, Purpose the burden of the information Federal Deposit Insurance Corporation, collection, including the validity of the 550 17th Street NW., NYA–5046, The Office of the Comptroller of the methodology and assumptions used; Washington, DC 20429. Currency (OCC), Board of Governors of (c) Ways to enhance the quality, • Hand Delivery: Comments may be the Federal Reserve System (Board), and utility, and clarity of the information to hand-delivered to the guard station at Federal Deposit Insurance Corporation be collected; the rear of the 550 17th Street Building (FDIC) (collectively the ‘‘agencies’’) are (d) Ways to minimize the burden of (located on F Street), on business days issuing this leveraged lending guidance the information collection on between 7 a.m. and 5 p.m. to update and replace the April 2001 respondents, including through the use As the final guidance discusses the Interagency guidance 1 regarding sound of automated collection techniques or importance of stress-testing as part of an practices for leveraged finance activities other forms of information technology; institution’s risk management practices (2001 guidance).2 The 2001 guidance and for leveraged lending activity, the addressed expectations for the content (e) Estimates of capital or start-up agencies note that they expect to review of credit policies, the need for well- costs and costs of operation, an institution’s policies and procedures defined underwriting standards, the maintenance, and purchase of services for stress-testing as part of their importance of defining an institution’s to provide information. supervisory processes. To the extent risk appetite for leveraged transactions, Comments on these questions should they collect information during an be directed to: examination about a financial 1 OCC Bulletin 2001–18; http://www.occ.gov/ OCC: Because paper mail in the institution’s stress-testing results, news-issuances/bulletins/2001/bulletin-2001– Washington, DC area and at the OCC is confidential treatment may be afforded 18.html; Board SR Letter 01–9, ‘‘Interagency subject to delay, commenters are Guidance on Leveraged Financing’’ April 9, 2001; to the records under exemption 8 of the http://www.federalreserve.gov/boarddocs/srletters/ encouraged to submit comments by Freedom of Information Act (FOIA), 5 2001/sr0109.html; and, FDIC Press Release PR–28– email if possible. Comments may be U.S.C. 552(b)(8). 2001; http://www.fdic.gov/news/news/press/2001/ sent to: Legislative and Regulatory pr2801.html. Activities Division, Office of the B. Regulatory Flexibility Act Analysis 2 For the purpose of this guidance, references to The final guidance is not a leveraged finance, or leveraged transactions Comptroller of the Currency, Attention: encompass the entire debt structure of a leveraged 1557–NEW, 400 7th Street SW., Suite rulemaking action. Thus, the Regulatory obligor (including loans and letters of credit, 3E–218, Mail Stop 9W–11, Washington, Flexibility Act (5 U.S.C. 603(b)) does not mezzanine tranches, senior and subordinated DC 20219. In addition, comments may apply to the guidance. However, the bonds) held by both bank and non-bank investors. agencies have considered the potential References to leveraged lending and leveraged loan be sent by fax to (571) 465–4326 or by transactions and credit agreements refer to all debt electronic mail to impact of the guidance on small banking with the exception of bond and high-yield debt held [email protected]. You may organizations. For the reasons discussed by both bank and non-bank investors.

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and the importance of stress-testing • Transactions structured to reflect a Risk Management Framework exposures and portfolios. sound business premise, an appropriate Given the high risk profile of Leveraged lending is an important capital structure, and reasonable cash leveraged transactions, financial type of financing for national and global flow and balance sheet leverage. institutions engaged in leveraged economies, and the U.S. financial Combined with supportable lending should adopt a risk industry plays an integral role in performance projections, these elements management framework that has an making credit available and syndicating of a safe-and-sound loan structure intensive and frequent review and that credit to investors. In particular, should clearly support a borrower’s monitoring process. The framework financial institutions should ensure they capacity to repay and to de-lever to a should have as its foundation written do not unnecessarily heighten risks by sustainable level over a reasonable risk objectives, risk acceptance criteria, 3 originating poorly underwritten loans. period, whether underwritten to hold or and risk controls. A lack of robust risk For example, a poorly underwritten distribute; management processes and controls at a • A definition of leveraged lending leveraged loan that is pooled with other financial institution with significant that facilitates consistent application loans or is participated with other leveraged lending activities could across all business lines; institutions may generate risks for the contribute to supervisory findings that • Well-defined underwriting financial system. This guidance is the financial institution is engaged in standards that, among other things, designed to assist financial institutions unsafe-and-unsound banking practices. define acceptable leverage levels and in providing leveraged lending to This guidance outlines the agencies’ describe amortization expectations for creditworthy borrowers in a safe-and- minimum expectations on the following sound manner. senior and subordinate debt; • A credit limit and concentration topics: Since the issuance of the 2001 • Definition of Leveraged Lending guidance, the agencies have observed framework consistent with the • General Policy Expectations periods of tremendous growth in the institution’s risk appetite; • • Participations Purchased volume of leveraged credit and in the Sound MIS that enable management • Underwriting Standards participation of unregulated investors. to identify, aggregate, and monitor • Valuation Standards Additionally, debt agreements have leveraged exposures and comply with • Pipeline Management frequently included features that policy across all business lines; • Strong pipeline management • provided relatively limited lender Reporting and Analytics policies and procedures that, among • protection including, but not limited to, Risk Rating Leveraged Loans other things, provide for real-time • the absence of meaningful maintenance Credit Analysis information on exposures and limits, • covenants in loan agreements or the Problem Credit Management and exceptions to the timing of expected • inclusion of payment-in-kind (PIK)- Deal Sponsors distributions and approved hold levels; • toggle features in junior capital Credit Review and, • instruments, which lessened lenders’ Stress-Testing • Guidelines for conducting periodic • recourse in the event of a borrower’s Conflicts of Interest portfolio and pipeline stress tests to • subpar performance. The capital Reputational Risk quantify the potential impact of • structures and repayment prospects for Compliance economic and market conditions on the some transactions, whether originated to institution’s asset quality, earnings, Definition of Leveraged Lending hold or to distribute, have at times been liquidity, and capital. aggressive. Moreover, management The policies of financial institutions information systems (MIS) at some Applicability should include criteria to define institutions have proven less than leveraged lending that are appropriate to This guidance updates and replaces the institution.5 For example, numerous satisfactory in accurately aggregating the existing 2001 guidance and forms exposures on a timely basis, with many definitions of leveraged lending exist the basis of the agencies’ supervisory throughout the financial services institutions holding large pipelines of focus and review of supervised financial higher-risk commitments at a time when industry and commonly contain some institutions, including any subsidiaries combination of the following: buyer demand for risky assets or affiliates. Implementation of this • diminished significantly. Proceeds used for buyouts, guidance should be consistent with the acquisitions, or capital distributions. This guidance updates and replaces size and risk profile of an institution’s • Transactions where the borrower’s the 2001 guidance in light of the leveraged activities relative to its assets, Total Debt divided by EBITDA (earnings developments and experience gained earnings, liquidity, and capital. before interest, taxes, depreciation, and since the time that guidance was issued. Institutions that originate or sponsor amortization) or Senior Debt divided by This guidance describes expectations for leveraged transactions should consider EBITDA exceed 4.0X EBITDA or 3.0X the sound risk management of leveraged all aspects and sections of the guidance. EBITDA, respectively, or other defined lending activities, including the In contrast, the vast majority of importance for institutions to develop community banks should not be affected complex, leveraged loans should have policies and and maintain: by this guidance as they have limited procedures commensurate with a larger, more involvement in leveraged lending. complex leveraged loan origination business. 3 For purposes of this guidance, the term Community and smaller institutions However, any financial institution that participates ‘‘financial institution’’ or ‘‘institution’’ includes that are involved in leveraged lending in leveraged lending transactions should follow national banks, federal savings associations, and applicable supervisory guidance provided in the federal branches and agencies supervised by the activities should discuss with their ‘‘Participations Purchased’’ section of this OCC; state member banks, bank holding companies, primary regulator the implementation of document. savings and loan holding companies, and all other cost-effective controls appropriate for 5 This guidance is not meant to include asset- institutions for which the Federal Reserve is the the complexity of their exposures and based loans unless such loans are part of the entire primary federal supervisor; and state nonmember 4 debt structure of a leveraged obligor. Asset-based banks, foreign banks having an insured branch, activities. lending is a distinct segment of the loan market that state savings associations, and all other institutions is tightly controlled or fully monitored, secured by for which the FDIC is the primary federal 4 The agencies do not intend that a financial specific assets, and usually governed by a supervisor. institution that originates a small number of less borrowing formula (or ‘‘borrowing base’’).

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levels appropriate to the industry or notional pipeline limits, the agencies loan documents, legal opinions, title sector.6 expect that financial institutions with insurance policies, Uniform Commercial • A borrower recognized in the debt significant leveraged transactions will Code (UCC) searches, and other relevant markets as a highly leveraged firm, implement underwriting limit documents; which is characterized by a high debt- frameworks that assess stress losses, flex • Carefully monitoring the borrower’s to-net-worth ratio. terms, economic capital usage, and performance throughout the life of the • Transactions when the borrower’s earnings at risk or that otherwise loan; and, post-financing leverage, as measured by provide a more nuanced view of • Establishing appropriate risk its leverage ratios (for example, debt-to- potential risk; 8 management guidelines as described in assets, debt-to-net-worth, debt-to-cash • Procedures for ensuring the risks of this document. flow, or other similar standards leveraged lending activities are Underwriting Standards common to particular industries or appropriately reflected in an sectors), significantly exceeds industry institution’s allowance for loan and A financial institution’s underwriting norms or historical levels.7 lease losses (ALLL) and capital standards should be clear, written and A financial institution engaging in adequacy analyses; measurable, and should accurately leveraged lending should define it • Credit and underwriting approval reflect the institution’s risk appetite for within the institution’s policies and authorities, including the procedures for leveraged lending transactions. A procedures in a manner sufficiently approving and documenting changes to financial institution should have clear detailed to ensure consistent application approved transaction structures and underwriting limits regarding leveraged across all business lines. A financial terms; transactions, including the size that the institution’s definition should describe • Guidelines for appropriate oversight institution will arrange both clearly the purposes and financial by senior management, including individually and in the aggregate for characteristics common to these adequate and timely reporting to the distribution. The originating institution transactions, and should cover risk to board of directors; should be mindful of reputational risks the institution from both direct • Expected risk-adjusted returns for associated with poorly underwritten exposure and indirect exposure via leveraged transactions; transactions, as these risks may find limited recourse financing secured by • Minimum underwriting standards their way into a wide variety of leveraged loans, or financing extended (see ‘‘Underwriting Standards’’ section investment instruments and exacerbate to financial intermediaries (such as below); and, systemic risks within the general conduits and special purpose entities • Effective underwriting practices for economy. At a minimum, an (SPEs)) that hold leveraged loans. primary loan origination and secondary institution’s underwriting standards General Policy Expectations loan acquisition. should consider the following: • Whether the business premise for Participations Purchased A financial institution’s credit each transaction is sound and the policies and procedures for leveraged Financial institutions purchasing borrower’s capital structure is lending should address the following: participations and assignments in • sustainable regardless of whether the Identification of the financial leveraged lending transactions should transaction is underwritten for the institution’s risk appetite including make a thorough, independent institution’s own portfolio or with the clearly defined amounts of leveraged evaluation of the transaction and the intent to distribute. The entirety of a lending that the institution is willing to risks involved before committing any borrower’s capital structure should underwrite (for example, pipeline funds.9 They should apply the same reflect the application of sound limits) and is willing to retain (for standards of prudence, credit financial analysis and underwriting example, transaction and aggregate hold assessment and approval criteria, and principles; levels). The institution’s designated risk in-house limits that would be employed • A borrower’s capacity to repay and appetite should be supported by an if the purchasing organization were ability to de-lever to a sustainable level analysis of the potential effect on originating the loan. At a minimum, over a reasonable period. As a general earnings, capital, liquidity, and other policies should include requirements guide, institutions also should consider risks that result from these positions, for: whether base case cash flow projections and should be approved by its board of • Obtaining and independently show the ability to fully amortize senior directors; analyzing full credit information both • secured debt or repay a significant A limit framework that includes before the participation is purchased portion of total debt over the medium limits or guidelines for single obligors and on a timely basis thereafter; term.10 Also, projections should include and transactions, aggregate hold • Obtaining from the lead lender one or more realistic downside portfolio, aggregate pipeline exposure, copies of all executed and proposed scenarios that reflect key risks identified and industry and geographic in the transaction; concentrations. The limit framework 8 Flex terms allow the arranger to change interest • Expectations for the depth and should identify the related management rate spreads during the syndication process to breadth of due diligence on leveraged adjust pricing to current liquidity levels. approval authorities and exception transactions. This should include tracking provisions. In addition to 9 Refer to other joint agency guidance regarding purchased participations: OCC Loan Portfolio Management Handbook, http://www.occ.gov/ 10 In general, the base case cash flow projection 6 Cash should not be netted against debt for publications/publications-by-type/comptrollers- is the borrower or deal sponsor’s expected estimate purposes of this calculation. handbook/lpm.pdf, Loan Participations, Board of financial performance using the assumptions that 7 The designation of a financing as ‘‘leveraged ‘‘Commercial Bank Examination Manual,’’ http:// are deemed most likely to occur. The financial lending’’ is typically made at loan origination, www.federalreserve.gov/boarddocs/supmanual/ results for the base case should be better than those modification, extension, or refinancing. ‘‘Fallen cbem/cbem.pdf, section 2045.1, Loan for the conservative case but worse than those for angels’’ or borrowers that have exhibited a Participations, the Agreements and Participants; the aggressive or upside case. A financial institution significant deterioration in financial performance and FDIC Risk Management Manual of Examination may make adjustments to the base case financial after loan inception and subsequently become Policies, section 3.2 (Loans), http://www.fdic.gov/ projections, if necessary. The most realistic highly leveraged would not be included within the regulations/safety/manual/section3- financial projections should be used when scope of this guidance, unless the credit is 2.html#otherCredit, Loan Participations, (last measuring a borrower’s capacity to repay and de- modified, extended, or refinanced. updated Feb. 2, 2005). lever.

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standards for evaluating various types of Nothing in the preceding standards valuation model that converts a future collateral, with a clear definition of should be considered to discourage series of cash flows into current value credit risk management’s role in such providing financing to borrowers by discounting those cash flows at a rate due diligence; engaged in workout negotiations, or as of return (referred to as the ‘‘discount • Standards for evaluating expected part of a pre-packaged financing under rate’’) that reflects the risk inherent risk-adjusted returns. The standards the bankruptcy code. Neither are they therein. This method is most should include identification of meant to discourage well-structured, appropriate when future cash flows are expected distribution strategies, standalone asset-based credit facilities cyclical or variable over time. Both including alternative strategies for to borrowers with strong lender income methods involve numerous funding and disposing of positions monitoring and controls, for which a assumptions, and therefore, supporting during market disruptions, and the financial institution should consider documentation should fully explain the potential for losses during such periods; separate underwriting and risk rating evaluator’s reasoning and conclusions. • The degree of reliance on enterprise guidance. When a borrower is experiencing a financial downturn or facing adverse value and other intangible assets for Valuation Standards loan repayment, along with acceptable market conditions, a lender should valuation methodologies, and guidelines Institutions often rely on enterprise reflect those adverse conditions in its for the frequency of periodic reviews of value and other intangibles when (1) assumptions for key variables such as those values; Evaluating the feasibility of a loan cash flow, earnings, and sales multiples • Expectations for the degree of request; (2) determining the debt when assessing enterprise value as a reduction potential of planned asset support provided by the sponsor (if potential source of repayment. Changes sales; (3) assessing a borrower’s ability any), taking into consideration the in the value of a borrower’s assets to access the capital markets; and, (4) sponsor’s financial capacity, the extent should be tested under a range of stress estimating the strength of a secondary of its capital contribution at inception, scenarios, including business conditions source of repayment. Institutions may and other motivating factors. more adverse than the base case also view enterprise value as a useful Institutions looking to rely on sponsor scenario. Stress tests of enterprise benchmark for assessing a sponsor’s support as a secondary source of values and their underlying economic incentive to provide financial repayment for the loan should be able assumptions should be conducted and support. Given the specialized to provide documentation, including, documented at origination of the knowledge needed for the development but not limited to, financial or liquidity transaction and periodically thereafter, of a credible enterprise valuation and incorporating the actual performance of statements, showing recently the importance of enterprise valuations the borrower and any adjustments to documented evidence of the sponsor’s in the underwriting and ongoing risk projections. The institution should willingness and ability to support the assessment processes, enterprise perform its own discounted cash flow credit extension; valuations should be performed by analysis to validate the enterprise value • Whether credit agreement terms qualified persons independent of an implied by proxy measures such as allow for the material dilution, sale, or institution’s origination function. multiples of cash flow, earnings, or exchange of collateral or cash flow- There are several methods used for sales. producing assets without lender valuing businesses. The most common Enterprise value estimates derived approval; valuation methods are assets, income, • from even the most rigorous procedures Credit agreement covenant and market. Asset valuation methods are imprecise and ultimately may not be protections, including financial consider an enterprise’s underlying realized. Therefore, institutions relying performance (such as debt-to-cash flow, assets in terms of its net going-concern on enterprise value or illiquid and hard- interest coverage, or fixed charge or liquidation value. Income valuation to-value collateral should have policies coverage), reporting requirements, and methods consider an enterprise’s that provide for appropriate loan-to- compliance monitoring. Generally, a ongoing cash flows or earnings and value ratios, discount rates, and leverage level after planned asset sales apply appropriate capitalization or collateral margins. Based on the nature (that is, the amount of debt that must be discounting techniques. Market of an institution’s leveraged lending serviced from operating cash flow) in valuation methods derive value activities, the institution should excess of 6X Total Debt/EBITDA raises multiples from comparable company establish limits for the proportion of concerns for most industries; data or sales transactions. However, individual transactions and the total • Collateral requirements in credit final value estimates should be based on portfolio that are supported by agreements that specify acceptable the method or methods that give enterprise value. Regardless of the collateral and risk-appropriate measures supportable and credible results. In methodology used, the assumptions and controls, including acceptable many cases, the income method is underlying enterprise-value estimates collateral types, loan-to-value generally considered the most reliable. should be clearly documented, well guidelines, and appropriate collateral There are two common approaches supported, and understood by the valuation methodologies. Standards for employed when using the income institution’s appropriate decision- asset-based loans that are part of the method. The ‘‘capitalized cash flow’’ makers and risk oversight units. Further, entire debt structure also should outline method determines the value of a an institution’s valuation methods expectations for the use of collateral company as the present value of all should be appropriate for the borrower’s controls (for example, inspections, future cash flows the business can industry and condition. independent valuations, and payment generate in perpetuity. An appropriate lockbox), other types of collateral and cash flow is determined and then Pipeline Management account maintenance agreements, and divided by a risk-adjusted capitalization Market disruptions can substantially periodic reporting requirements; and, rate, most commonly the weighted impede the ability of an underwriter to • Whether loan agreements provide average cost of capital. This method is consummate syndications or otherwise for distribution of ongoing financial and most appropriate when cash flows are sell down exposures, which may result other relevant credit information to all predictable and stable. The ‘‘discounted in material losses. Accordingly, participants and investors. cash flow’’ method is a multiple-period financial institutions should have strong

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risk management and controls over • Policies and procedures addressing • Exposures and performance by deal transactions in the pipeline, including the use of hedging to reduce pipeline sponsors. Deals introduced by sponsors amounts to be held and those to be and hold exposures, which should may, in some cases, be considered distributed. A financial institution address acceptable types of hedges and exposure to related borrowers. An should be able to differentiate the terms considered necessary for institution should identify, aggregate, transactions according to tenor, investor providing a net credit exposure after and monitor potential related exposures; class (for example, pro-rata and hedging; and, • Gross and net exposures, hedge institutional), structure, and key • Plans and provisions addressing counterparty concentrations, and policy borrower characteristics (for example, contingent liquidity and compliance exceptions; industry). with the Board’s Regulation W (12 CFR • Actual versus projected distribution In addition, an institution should part 223) when market illiquidity or of the syndicated pipeline, with regular develop and maintain: credit conditions change, interrupting reports of excess levels over the hold • A clearly articulated and normal distribution channels. targets for the syndication inventory. documented appetite for underwriting Pipeline definitions should clearly Reporting and Analytics risk that considers the potential effects identify the type of exposure. This on earnings, capital, liquidity, and other The agencies expect financial includes committed exposures that have risks that result from pipeline institutions to diligently monitor higher not been accepted by the borrower, exposures; risk credits, including leveraged loans. commitments accepted but not closed, • Written policies and procedures for A financial institution’s management and funded and unfunded commitments defining and managing distribution should receive comprehensive reports that have closed but have not been failures and ‘‘hung’’ deals, which are about the characteristics and trends in distributed; • identified by an inability to sell down such exposures at least quarterly, and Total and segmented leveraged the exposure within a reasonable period summaries should be provided to the lending exposures, including (generally 90 days from transaction institution’s board of directors. Policies subordinated debt and equity holdings, closing). The financial institution’s and procedures should identify the alongside established limits. Reports board of directors and management fields to be populated and captured by should provide a detailed and should establish clear expectations for a financial institution’s MIS, which comprehensive view of global the disposition of pipeline transactions should yield accurate and timely exposures, including situations when an that have not been sold according to reporting to management and the board institution has indirect exposure to an their original distribution plan. Such of directors that may include the obligor or is holding a previously sold transactions that are subsequently following: position as collateral or as a reference • Individual and portfolio exposures asset in a derivative; reclassified as hold-to-maturity should • also be reported to management and the within and across all business lines and Borrower and counterparty board of directors; legal vehicles, including the pipeline; leveraged lending reporting should • Guidelines for conducting periodic • Risk rating distribution and consider exposures booked in other stress tests on pipeline exposures to migration analysis, including business units throughout the quantify the potential impact of maintenance of a list of those borrowers institution, including indirect exposures changing economic and market who have been removed from the such as default swaps and total return conditions on the institution’s asset leveraged portfolio due to swaps, naming the distributed paper as quality, earnings, liquidity, and capital; improvements in their financial a covered or referenced asset or • Controls to monitor performance of characteristics and overall risk profile; collateral exposure through repo the pipeline against original • Industry mix and maturity profile; transactions. Additionally, the expectations, and regular reports of • Metrics derived from probabilities institution should consider positions variances to management, including the of default and loss given default; held in available-for-sale or traded amount and timing of syndication and • Portfolio performance measures, portfolios or through structured distribution variances, and reporting of including noncompliance with investment vehicles owned or recourse sales to achieve distribution; covenants, restructurings, sponsored by the originating institution or its subsidiaries or affiliates. • Reports that include individual and delinquencies, non-performing aggregate transaction information that amounts, and charge-offs; Risk Rating Leveraged Loans • accurately risk rates credits and portrays Amount of impaired assets and the Previously, the agencies issued risk and concentrations in the pipeline; nature of impairment (that is, • guidance on rating credit exposures and Limits on aggregate pipeline permanent, or temporary), and the credit rating systems, which applies to commitments; amount of the ALLL attributable to all credit transactions, including those • Limits on the amount of loans that leveraged lending; 11 • in the leveraged lending category. an institution is willing to retain on its The aggregate level of policy The risk rating of leveraged loans own books (that is, borrower, exceptions and the performance of that involves the use of realistic repayment counterparty, and aggregate hold levels), portfolio; assumptions to determine a borrower’s • and limits on the underwriting risk that Exposures by collateral type, ability to de-lever to a sustainable level will be undertaken for amounts including unsecured transactions and within a reasonable period of time. For intended for distribution; those where enterprise value will be the example, supervisors commonly assume • Policies and procedures that source of repayment for leveraged loans. that the ability to fully amortize senior identify acceptable accounting Reporting should also consider the methodologies and controls in both implications of defaults that trigger pari 11 Board SR Letter 98–25 ‘‘Sound Credit Risk functional as well as dysfunctional passu treatment for all lenders and, Management and the Use of Internal Credit Risk markets, and that direct prompt thus, dilute the secondary support from Ratings at Large Banking Organizations;’’ OCC recognition of losses in accordance with the sale of collateral; Comptroller’s Handbooks ‘‘Rating Credit Risk’’ and • ‘‘Leveraged Lending’’, and FDIC Risk Management generally accepted accounting Secondary market pricing data and Manual of Examination Policies, ‘‘Loan Appraisal principles; trading volume, when available; and Classification.’’

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secured debt or the ability to repay at plan, the related risk implications, and monitor a sponsor’s financial condition. least 50 percent of total debt over a five- the accuracy of risk ratings and accrual Deal sponsors may provide valuable to-seven year period provides evidence status. From inception, the credit file support to borrowers such as strategic of adequate repayment capacity. If the should contain a chronological rationale planning, management, and other projected capacity to pay down debt for and analysis of all substantive tangible and intangible benefits. from cash flow is nominal with changes to the borrower’s operating plan Sponsors may also provide sources of refinancing the only viable option, the and variance from expected financial financial support for borrowers that fail credit will usually be adversely rated performance; to achieve projections. Generally, a even if it has been recently • Enterprise and collateral valuations financial institution rates a borrower underwritten. In cases when leveraged are independently derived or validated based on an analysis of the borrower’s loan transactions have no reasonable or outside of the origination function, are standalone financial condition. realistic prospects to de-lever, a timely, and consider potential value However, a financial institution may substandard rating is likely. erosion; consider support from a sponsor in Furthermore, when assessing debt • Collateral liquidation and asset sale assigning internal risk ratings when the service capacity, extensions and estimates are based on current market institution can document the sponsor’s restructures should be scrutinized to conditions and trends; history of demonstrated support as well • ensure that the institution is not merely Potential collateral shortfalls are as the economic incentive, capacity, and masking repayment capacity problems identified and factored into risk rating stated intent to continue to support the by extending or restructuring the loan. and accrual decisions; transaction. However, even with • If the primary source of repayment Contingency plans anticipate documented capacity and a history of becomes inadequate, the agencies changing conditions in debt or equity support, the sponsor’s potential believe that it would generally be markets when exposures rely on contributions may not mitigate inappropriate for an institution to refinancing or the issuance of new supervisory concerns absent a consider enterprise value as a secondary equity; and, • documented commitment of continued source of repayment unless that value is The borrower is adequately support. An evaluation of a sponsor’s well supported. Evidence of well- protected from interest rate and foreign financial support should include the supported value may include binding exchange risk. following: purchase and sale agreements with Problem Credit Management • The sponsor’s historical qualified third parties or thorough asset performance in supporting its A financial institution should valuations that fully consider the effect investments, financially and otherwise; of the borrower’s distressed formulate individual action plans when • The sponsor’s economic incentive circumstances and potential changes in working with borrowers experiencing to support, including the nature and business and market conditions. For diminished operating cash flows, amount of capital contributed at such borrowers, when a portion of the depreciated collateral values, or other inception; loan may not be protected by pledged significant plan variances. Weak initial • Documentation of degree of support assets or a well-supported enterprise underwriting of transactions, coupled (for example, a guarantee, comfort letter, value, examiners generally will rate that with poor structure and limited or verbal assurance); portion doubtful or loss and place the covenants, may make problem credit • Consideration of the sponsor’s loan on nonaccrual status. discussions and eventual restructurings contractual investment limitations; more difficult for an institution as well • To the extent feasible, a periodic Credit Analysis as result in less favorable outcomes. review of the sponsor’s financial Effective underwriting and A financial institution should statements and trends, and an analysis management of leveraged lending risk is formulate credit policies that define of its liquidity, including the ability to highly dependent on the quality of expectations for the management of fund multiple deals; analysis employed during the approval adversely rated and other high-risk • Consideration of the sponsor’s process as well as ongoing monitoring. borrowers whose performance departs dividend and capital contribution A financial institution’s policies should significantly from planned cash flows, practices; address the need for a comprehensive asset sales, collateral values, or other • The likelihood of the sponsor assessment of financial, business, important targets. These policies should supporting a particular borrower industry, and management risks stress the need for workout plans that compared to other deals in the sponsor’s including, whether contain quantifiable objectives and portfolio; and, • Cash flow analyses rely on overly measureable time frames. Actions may • Guidelines for evaluating the optimistic or unsubstantiated include working with the borrower for qualifications of a sponsor and a process projections of sales, margins, and an orderly resolution while preserving to regularly monitor the sponsor’s merger and acquisition synergies; the institution’s interests, sale of the performance. • credit in the secondary market, or Liquidity analyses include Credit Review performance metrics appropriate for the liquidation of collateral. Problem credits borrower’s industry; predictability of should be reviewed regularly for risk A financial institution should have a the borrower’s cash flow; measurement rating accuracy, accrual status, strong and independent credit review of the borrower’s operating cash needs; recognition of impairment through function that demonstrates the ability to and ability to meet debt maturities; specific allocations, and charge-offs. identify portfolio risks and documented • Projections exhibit an adequate authority to escalate inappropriate risks Deal Sponsors margin for unanticipated merger-related and other findings to their senior integration costs; A financial institution that relies on management. Due to the elevated risks • Projections are stress tested for one sponsor support as a secondary source inherent in leveraged lending, and or more downside scenarios, including of repayment should develop guidelines depending on the relative size of a a covenant breach; for evaluating the qualifications of financial institution’s leveraged lending • Transactions are reviewed at least financial sponsors and should business, the institution’s credit review quarterly to determine variance from implement processes to regularly function should assess the performance

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of the leveraged portfolio more Conflicts of Interest principles of safety and soundness and frequently and in greater depth than A financial institution should develop other agency guidance related to other segments in the loan portfolio. appropriate policies and procedures to commercial lending. Such assessments should be performed address and to prevent potential In particular, because leveraged by individuals with the expertise and conflicts of interest when it has both transactions often involve a variety of experience for these types of loans and equity and lending positions. For types of debt and bank products, a the borrower’s industry. Portfolio example, an institution may be reluctant financial institution should ensure that reviews should generally be conducted to use an aggressive collection strategy its policies incorporate safeguards to at least annually. For many financial with a problem borrower because of the prevent violations of anti-tying institutions, the risk characteristics of potential impact on the value of an regulations. Section 106(b) of the Bank Holding Company Act Amendments of leveraged portfolios, such as high institution’s equity interest. A financial 13 reliance on enterprise value, institution may encounter pressure to 1970 prohibits certain forms of product tying by financial institutions concentrations, adverse risk rating provide financial or other privileged and their affiliates. The intent behind trends, or portfolio performance, may client information that could benefit an Section 106(b) is to prevent financial dictate more frequent reviews. affiliated equity investor. Such conflicts also may occur when the underwriting institutions from using their market A financial institution should staff its financial institution serves as financial power over certain products to obtain an internal credit review function advisor to the seller and simultaneously unfair competitive advantage in other appropriately and ensure that the offers financing to multiple buyers (that products. function has sufficient resources to is, stapled financing). Similarly, there In addition, equity interests and ensure timely, independent, and may be conflicting interests among the certain debt instruments used in accurate assessments of leveraged different lines of business within a leveraged transactions may constitute lending transactions. Reviews should financial institution or between the ‘‘securities’’ for the purposes of federal evaluate the level of risk, risk rating financial institution and its affiliates. securities laws. When securities are integrity, valuation methodologies, and When these situations occur, potential involved, an institution should ensure the quality of risk management. Internal conflicts of interest arise between the compliance with applicable securities credit reviews should include the financial institution and its customers. laws, including disclosure and other review of the institution’s leveraged Policies and procedures should clearly regulatory requirements. An institution lending practices, policies, and define potential conflicts of interest, should also establish policies and procedures to ensure that they are identify appropriate risk management procedures to appropriately manage the consistent with regulatory guidance. controls and procedures, enable internal dissemination of material, employees to report potential conflicts nonpublic information about Stress-Testing of interest to management for action transactions in which it plays a role. A financial institution should develop without fear of retribution, and ensure Dated: February 19, 2013. and implement guidelines for compliance with applicable laws. Thomas J. Curry, conducting periodic portfolio stress Further, management should have an Comptroller of the Currency. established training program for tests on loans originated to hold as well Board of Governors of the Federal Reserve employees on appropriate practices to as loans originated to distribute, and System, March 8, 2013. follow to avoid conflicts of interest, and sensitivity analyses to quantify the Robert deV. Frierson, provide for reporting, tracking, and potential impact of changing economic Secretary of the Board. resolution of any conflicts of interest Dated at Washington, DC, this 11th day of and market conditions on its asset that occur. quality, earnings, liquidity, and March, 2013. capital.12 The sophistication of stress- Reputational Risk Federal Deposit Insurance Corporation. testing practices and sensitivity analyses Leveraged lending transactions are Valerie J. Best, should be consistent with the size, often syndicated through the financial Assistant Executive Secretary. complexity, and risk characteristics of and institutional markets. A financial [FR Doc. 2013–06567 Filed 3–21–13; 8:45 am] the institution’s leveraged loan institution’s apparent failure to meet its BILLING CODE 4810–33–P; 6210–01–P; 6714–01–P portfolio. To the extent a financial legal responsibilities in underwriting institution is required to conduct and distributing transactions can enterprise-wide stress tests, the damage its market reputation and DEPARTMENT OF THE TREASURY leveraged portfolio should be included impair its ability to compete. Similarly, Internal Revenue Service in any such tests. a financial institution that distributes transactions which over time have Community Volunteer Income Tax 12 See interagency guidance ‘‘Supervisory significantly higher default or loss rates Assistance (VITA) Matching Grant Guidance on Stress-Testing for Banking and performance issues may also see its Program—Availability of Application Organizations With More Than $10 Billion in Total reputation damaged. Consolidated Assets,’’ Final Supervisory Guidance, Packages 77 FR 29458 (May 17, 2012), at http://www.gpo.gov/ Compliance fdsys/pkg/FR-2012-05-17/html/2012-11989.htm, AGENCY: Internal Revenue Service (IRS), and the joint ‘‘Statement to Clarify Supervisory The legal and regulatory issues raised Treasury. Expectations for Stress-Testing by Community by leveraged transactions are numerous ACTION: Banks,’’ May 14, 2012, by the OCC at http:// Notice. www.occ.gov/news-issuances/news-releases/2012/ and complex. To ensure potential nr-ia-2012-76a.pdf; the Board at conflicts are avoided and laws and SUMMARY: This document provides www.federalreserve.gov/newsevents/press/bcreg/ regulations are adhered to, an notice of the availability of the bcreg20120514b1.pdf; and the FDIC at http:// institution’s independent compliance application package for the 2014 www.fdic.gov/news/news/press/2012/pr12054a.pdf. Community Volunteer Income Tax See also FDIC Final Rule, Annual Stress Test, 77 FR function should periodically review the 62417 (Oct. 15, 2012) (to be codified at 12 CFR part institution’s leveraged lending activity. 325, subpart. C). This guidance is consistent with the 13 12 U.S.C. 1972.

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