Subordinated Debt

Subordinated Debt

Comptroller’s Licensing Manual

Washington, DC
November 2003

Subordinated Debt

Table of Contents

Introduction............................................................................................................. 1
Key Policies ............................................................................................................. 1
General ........................................................................................................ 1
Criteria to Qualify as Capital......................................................................... 2
Decision Criteria...................................................................................................... 3
Application Process ................................................................................................. 3
Prior Approval .............................................................................................. 3
Notice .......................................................................................................... 4
Legal Lending Limit and Other Statutory Limits............................................. 4
Mandatory Convertible Debt ........................................................................ 4
Reciprocal Holdings ..................................................................................... 5
Shareholders’ Approval................................................................................. 5
Securities Disclosure Requirements .............................................................. 5
Procedures............................................................................................................... 6
Appendix A: Guidelines for Subordinated Debt.................................................... 10
Appendix B: Sample Subordinated Note............................................................... 18
Glossary ................................................................................................................ 21
References ............................................................................................................. 22

ii

Subordinated Debt
Introduction
National banks may issue subordinated debt. However, the subordinated debt must
satisfy certain requirements to qualify as regulatory capital. Generally, a bank does
not need the Comptroller of the Currency’s (OCC) prior approval to issue or prepay
subordinated debt (including payment pursuant to an acceleration clause or
redemption prior to maturity), provided that the bank will remain an eligible bank
after completing the transaction. However, prior OCC approval to issue or prepay
subordinated debt is needed when:
•

The law requires it (for example, 12 USC 1831o(h), which deals with severely
undercapitalized banks).

•

The OCC notifies the bank that prior approval is required.

•

The bank is not an eligible bank either prior to or following a prepayment of
subordinated debt.

If a bank intends to count the subordinated debt as Tier 2 or Tier 3 capital, it must
notify the OCC in writing within 10 days of issuing the subordinated debt. No
approval or notice is needed to issue or prepay subordinated debt that will not
count as Tier 2 or Tier 3 capital, unless the OCC instructs the bank otherwise.
Sales of subordinated debt securities are subject to the securities offering disclosure
requirements at 12 CFR 16.
This booklet should be used together with other booklets of the Comptroller’s
Licensing Manual; for example, the ”General Policies and Procedures” booklet for a
discussion of general filing instructions and procedures. There is also a step-by-step
procedures section for applicants and the OCC to follow and a glossary of the terms
used in this booklet. The reference section includes applicable laws, regulations,
and OCC issuances to assist applicants in completing the filing process. Throughout
the booklet, there are hyperlinks to other related booklets and to filing samples.

Key Policies
General
The OCC generally considers the issuance and prepayment of subordinated debt to
be bank management decisions. When the OCC determines that its prior approval
is required for a bank either to issue or prepay subordinated debt, approval may be
withheld for a bank that:
•

Fails to comply with a capital plan submitted to the OCC.

•

Proposes a capital structure that the OCC considers inadequate.
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•

Exhibits conditions that threaten its safety and soundness.

•

Fails to provide adequate information.

Criteria to Qualify as Capital
To be considered as Tier 2 capital, subordinated debt must meet the requirements of
12 CFR 3, Appendix A, section 2(b)(4), and comply with the ”OCC Guidelines for
Subordinated Debt” in the Appendix of this booklet. Subordinated debt eligible to
be considered as Tier 2 capital must:
•

Have an original weighted average maturity of at least five years.

•

State on the instrument that it is not a deposit and is not insured by the Federal
Deposit Insurance Corporation (FDIC).

•

Be subordinated to the claims of depositors.

•

Be defined as capital according to 12 CFR 3 or any other OCC rule, regulation,
or policy.

•

Be unsecured.

•

Be ineligible as collateral for a loan made by the issuing bank.

•

Provide that once any scheduled payments of principal begin, all payments shall
be made at least annually and the amount repaid each year shall be no less than
in the prior year.

•

Comply with securities offering disclosure requirements under the federal
securities laws and OCC regulations, 12 CFR 16.

The total amount of subordinated debt that a bank may consider as Tier 2 capital is
limited. Subordinated debt plus any intermediate-term, preferred stock plus related
surplus included in Tier 2 are limited to 50 percent of the bank’s Tier 1 capital. The
OCC will require the debt to be subordinated to the obligations of all creditors,
except those specifically designated as ranking on a parity with, or subordinated to,
the note.
The amount of subordinated debt eligible for inclusion as Tier 2 capital is reduced
by 20 percent of the original amount of the instrument (net of any redemptions) at
the beginning of each of the last five years of the instrument’s life. Thus,
subordinated debt with less than one year to maturity is not included in Tier 2
capital.
In addition to Tier 2 capital, certain subordinated debt may qualify as Tier 3 capital.
Tier 3 capital is limited in its use to satisfying the market risk capital requirements.
To be considered as Tier 3 capital, the subordinated debt must meet the
requirements of 12 CFR 3, Appendix B, section 2(d), which specify that the
subordinated debt must:
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•

Be unsecured and fully paid up.

•

Have an original maturity of at least two years.

•

Include a provision that the subordinated debt is not redeemable before maturity
without prior OCC approval.

•

Include a lock-in clause precluding payment of either interest or principal (even
at maturity), if the payment would cause the issuing bank’s risk-based capital
ratio to fall or remain below the minimum required under 12 CFR 3, Appendix
A.

•

Neither contain nor be covered by any covenants, terms, or restrictions that are
inconsistent with safe and sound banking practices.

Decision Criteria
To assess compliance with key policies and the criteria for qualifying capital for
proposed issuances of subordinated debt instruments, the OCC will concentrate on
provisions that:
•

Accelerate the repayment date of the indebtedness.

•

Restrict the bank from engaging in activities that would otherwise be
permissible.

•

Place note holders in a secured creditor status or give them priority over other
creditors.

Application Process
Prior Approval
A bank is required to obtain the OCC’s prior approval to issue subordinated debt if
(a) it is not well capitalized regardless of whether the subordinated debt is intended
to count as capital, or (b) the OCC has previously notified the bank that prior
approval is required. A bank that needs prior OCC approval to issue or prepay
subordinated debt must apply to the appropriate OCC office. The application is
considered approved as of the 30th day after the OCC’s receipt, unless the OCC
specifically notifies the bank otherwise.
The subordinated debt should be issued within one year of approval. A bank that is
required to and receives OCC’s prior approval to prepay subordinated debt also
must notify the OCC within 10 days of completion of the transaction. This notice
should include:
•

The amount and date on which the reduction occurred.

•

A statement that the change in the bank’s capital structure complies with
applicable laws and regulations.
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Notice
Although an ”eligible bank,” as defined in the Glossary section of this booklet, is not
required to obtain the OCC’s prior approval before issuing subordinated debt, the
bank must notify the OCC in writing within 10 days after the issuance of the
subordinated debt for it to be considered as Tier 2 or Tier 3 capital. The notice must
include:
•

A description of the terms of the issuance.

•

The date the funds were received and the amount.

•

A copy of the final subordinated note format and agreement.

•

A statement of whether the subordinated debt was issued to another bank that
holds any capital instrument of the bank.

•

A statement that the issuance complies with all relevant laws, regulations, and
“Guidelines for Subordinated Debt” in Appendix A of this booklet.

Once satisfied that the requirements have been met, the OCC will issue a letter to
the bank acknowledging receipt of the notice.
Unless the OCC instructs otherwise, a bank is not required to submit a notice for the
prepayment of subordinated debt.

Lending Limit and Other Statutory Limits
When a subordinated debt issuance or prepayment results in a change in capital for
purposes of 12 USC 1831o and 12 CFR 6 (prompt corrective action), the OCC will
issue a letter confirming that the bank should begin to calculate its lending limit
based on the resulting capital. The letter will state the effective date of such change.

Mandatory Convertible Debt
Mandatory convertible debt is considered a hybrid capital instrument (see
discussion in “Capital and Dividends” booklet). Mandatory convertible debt must
require without qualification that the issuer exchange either common or perpetual
preferred stock for such instruments by a date at or before the maturity of the
instrument. The maturity must be 12 years or less. In addition, the instrument must
meet the requirements of 12 CFR 3.1000(f)(1)(i) - (v). Mandatory convertible debt is
eligible to be included in Tier 2 capital without limitation if it meets all of the
requirements described above as well as those for hybrid instruments listed in
12 CFR 3, Appendix A, section 2(b)(3).

4

Reciprocal Holdings
A bank that purchases, exchanges, swaps, or otherwise agrees to hold the
subordinated debt of another bank that holds any capital instruments of the
purchasing bank, must deduct the amount it purchased from its own capital for both
capital adequacy under 12 CFR 3, Appendix A, section 2(c)(6), and the
Consolidated Reports of Condition and Income (call reports). A national bank that
issues subordinated debt must disclose in its application (if needed), or notice to the
OCC, whether another bank that holds any capital instruments of the bank will or
did purchase the subordinated debt. Subordinated debt of one bank received by
another in satisfaction of debts previously contracted does not need to be deducted
from the capital of the receiving bank, provided that the holding bank has not held
the debt for more than five years.

Shareholders’ Approval
The OCC does not require that a bank either obtain shareholder approval for the
issuance or prepayment of subordinated debt or amend its Articles of Association to
authorize the issuance or prepayment of such subordinated debt.

Securities Disclosure Requirements
When selling subordinated debt securities, a bank must comply with the registration
requirements or otherwise qualify for an exemption under 12 CFR 16. This
requirement applies even if the bank is not required to obtain prior approval to issue
subordinated debt.
Registration statements or other required documents should be filed with the OCC’s
Securities and Corporate Practices Division (SCP) in Washington, DC.

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Procedures
Licensing Staff
1. Refers a bank that requests instructions to the “General Policies and
Procedures” booklet and this booklet of the Comptroller’s Licensing Manual.

Prior Approval Requests
(Steps 2 through 22 apply only when a bank is required to obtain OCC
approval prior to issuing or prepaying subordinated debt. Eligible banks, those
not needing OCC prior approval, should go to step 23.)

Bank
2. Submits a complete application and filing fee to the licensing manager at the
appropriate district office.

Review
Licensing Staff
3. Initiates and enters appropriate information into the Corporate Activities
Information System (CAIS).
4. Notifies appropriate assistant deputy comptroller (ADC) and supervisory analyst
of receipt of application.
5. Establishes the official file to maintain all original documents.
6. Forwards the filing fee and the deposit memorandum (Form 6043-01) to the
Comptroller of the Currency, Attention: Accounts Receivable, 250 E Street,
S.W., MS 4-8, Washington, DC 20219. Retains a copy of the memorandum.
Requests the filing fee if it was not received.
7. Within five business days of receipt of the application:
•

Reviews the application and other relevant information about the bank to
determine whether the application contains all information necessary to
reach a decision.
–

If yes, notifies the bank of receipt of the application and the target
date for decision. Also, provides the CAIS Control Number.

–

If no, requests the missing information from the bank, specifying a
response date. Also informs the bank whether the 30-day automatic
approval date remains in effect.
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•

Solicits comments from the ADC, supervisory analyst, and other OCC
divisions, as appropriate, with preliminary responses required within 15
days after receipt.

•

Contacts the supervisory office staff to ascertain the status of the bank’s
capital plan if the bank is undercapitalized.

•

If a legal question is identified or a legal opinion was submitted with the
application, forwards the relevant material to the Law Department,
specifying that a preliminary response is required within 15 days after
receipt.

8. If at any time the application presents significant policy, legal, or supervisory
issues, contacts Headquarters Licensing (HQ LIC) to decide:
•

Whether the application should be filed with the Washington office, if
broad issues are involved.

•

If specific issues should be carved out for Washington action, while the
application continues to be processed in the appropriate district office.

•

When the filings should be forwarded to Washington.

9. Upon receipt of any comments or prior to the end of the 30-day automatic
approval period, determines whether the application remains qualified for prior
approval. If not, immediately notifies the bank, identifying the specific
reason(s) for failing to grant prior approval.

Decision
Licensing Staff
10. Decides the application under delegated authority or forwards the official file
to HQ LIC for decision. If referred to HQ LIC, goes to step 16.
11. Notifies the bank and, if appropriate, any interested parties. Notifies the
appropriate ADC and supervisory analyst of the decision by forwarding
updated CAIS comments and an electronic copy of the decision letter.
12. Sends the bank the decision letter and a Satisfaction Survey.
13. If the decision is either denial or conditional approval, forwards a copy of the
Confidential Memorandum, decision document, and transmittal letter to the
Director, Licensing Policy and Systems.
14. Makes appropriate CAIS entries.
15. If the application is denied, goes to step 30.

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HQ LIC
16. Makes appropriate CAIS entries.
17. Reviews the file and all relevant information, solicits comments from other
OCC divisions as appropriate, makes a recommendation, and forwards the
official file to the appropriate official for decision.
18. Once decided, notifies the bank and district of the decision. Notifies the
appropriate ADC and supervisory analyst of the decision by forwarding
updated CAIS comments and an electronic copy of the decision letter.
19. Sends the bank the decision letter and a Satisfaction Survey, and notifies any
interested parties (if applicable).
20. If the decision is either denial or conditional approval, forwards a copy of the
confidential memorandum and decision document to the Director, Licensing
Policy and Systems.
21. Makes appropriate CAIS entries.
22. If approved or conditionally approved, returns the official file to the
appropriate district office. If denied, goes to step 30.

Securities Review
Bank
23. Before commencing the sale of the securities, prepares and files with SCP a
registration statement or any other documents required under 12 CFR 16.

Notice of Completed Changes
Bank
24. Notifies the licensing manager within 10 days of the transaction that the
changes in subordinated debt occurred. If prior approval not required, files a
notice as previously discussed in the “Notice” section.

Authorizations
Licensing Staff
25. Reviews the bank’s notification letter and documents to determine that all
required information has been submitted. When prior approval was required,
also reviews the official file to determine that all required actions occurred.
26. Notifies the bank by telephone and letter or e-mail, if necessary, of any
problems.
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27. Prepares and mails letter to the bank to acknowledge receipt of the notice.
Retains a copy in the official file. When prior approval is required, the
approval letter will notify the bank whether the subordinated debt qualifies as
Tier 2 or Tier 3 capital. The letter acknowledging the notice is authorization
for subsequent reductions/conversions in capital, which correspond to the
terms and maturity of the note instrument.
28. Notifies the appropriate supervisory office if the change results in a new capital
category under 12 CFR 6—Prompt Corrective Action.
29. Makes appropriate CAIS entries.

Close Out
Licensing Manager/HQ LIC
30. Reviews the official file for completeness and forwards it to Central Records.
31. Makes appropriate CAIS entries.

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Appendix A: Guidelines for Subordinated Debt
1. Mandatory Provisions
The following language, which has been drafted to comply with the
requirements of applicable rules, regulations, and policies, must appear in
every note, debenture, or note agreement.
A.

On the face of the note: ”THIS OBLIGATION IS NOT A DEPOSIT AND IS
NOT INSURED BY THE FEDERAL DEPOSIT INSURANCE
CORPORATION.”
Reference: 12 CFR 3.100(f)(1)(ii).

B.

On the face of the note: ”THIS OBLIGATION IS SUBORDINATED TO
CLAIMS OF DEPOSITORS, IS UNSECURED, AND IS INELIGIBLE AS
COLLATERAL FOR A LOAN BY THE (NAME OF ISSUING BANK).”
(Note: This clause may be combined with the required language set forth
in (1)(A), above.)
Reference: 12 CFR 3.100 (f)(1)(i), (iii), (iv), and (v).

C.

A general subordination clause must be added that specifies the
subordination of the note to obligations of the Federal Reserve, Federal
Deposit Insurance Corporation (FDIC), and other general creditors. The
clause must be in substantially the following form:
”The indebtedness of the bank evidenced by this note, including the
principal and premium, if any, and interest shall be subordinate and
junior in right of payment to its obligations to its depositors, its
obligations under bankers’ acceptances and letters of credit, and its
obligations to its other creditors, including its obligations to the Federal
Reserve Bank, Federal Deposit Insurance Corporation (FDIC), and any
rights acquired by the FDIC as a result of loans made by the FDIC to the
bank or the purchase or guarantee of any of its assets by the FDIC
pursuant to the provisions of 12 USC 1823(c), (d) or (e), whether now
outstanding or hereafter incurred. In the event of any insolvency,
receivership, conservatorship, reorganization, readjustment of debt,
marshaling of assets and liabilities or similar proceedings or any
liquidation or winding up of or relating to the bank, whether voluntary or
involuntary, all such obligations shall be entitled to be paid in full before
any payment shall be made on account of the principal of, or premium, if
any, or interest, on the note. In the event of any such proceedings, after
payment in full of all sums owing on such prior obligations, the holder, of
the note, together with any obligations of the bank ranking on a parity
with the note, shall be entitled to be paid from the remaining assets of the
bank the unpaid principal thereof and any unpaid premium, if any, and
interest before any payment or other distribution, whether in cash,
property, or otherwise, shall be made on account of any capital stock or
any obligations of the bank ranking junior to the notes.
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Nothing herein shall impair the obligation of the bank, which is absolute
and unconditional, to pay the principal of and any premium and interest
on the note according to its terms.”
D. To clarify for the purchaser the Comptroller’s flexibility in insolvency
cases, the following paragraph (or one which is substantially equivalent)
must be included:
”Notwithstanding any other provisions of this note, including specifically
those set forth in the sections relating to subordination, events of default
and covenants of the bank, it is expressly understood and agreed that the
Office of the Comptroller of the Currency (OCC) or any receiver or
conservator of the bank appointed by the OCC shall have the right in the
performance of his legal duties, and as part of liquidation designed to
protect or further the continued existence of the bank or the rights of any
parties or agencies with an interest in, or claim against, the bank or its
assets, to transfer or direct the transfer of the obligations of this note to
any bank or bank holding company selected by such official which shall
expressly assume the obligation of the due and punctual payment of the
unpaid principal, and interest and premium, if any, on this note and the
due and punctual performance of all covenants and conditions; and the
completion of such transfer and assumption shall serve to supersede and
void any default, acceleration or subordination which may have
occurred, or which may occur due or related to such transaction, plan,
transfer or assumption, pursuant to the provisions of this note, and shall
serve to return the holder to the same position, other than for substitution
of the obligor, it would have occupied had no default, acceleration or
subordination occurred; except that any interest and principal previously
due, other than by reason of acceleration, and not paid shall, in the
absence of a contrary agreement by the holder of this note, be deemed to
be immediately due and payable as of the date of such transfer and
assumption, together with the interest from its original due date at the rate
provided for herein.”
E.

Issues of subordinated notes and debentures, except mandatory
convertible debt, must have an original weighted average maturity of at
least five years.
Reference: 12 CFR 3.100(f)(1).

F.

Mandatory convertible debt must require without qualification that the
issuer exchange either common or perpetual preferred stock for such
instruments by a date at or before the maturity of the instrument. The
maturity must be 12 years or less.
Reference: 12 CFR 3.100(e)(5).

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2.

OCC Policy on Other Provisions
In reviewing the purchase agreement and note, the Licensing staff must allow
the bank flexibility in conducting its daily affairs. The following discussion
lists some areas that require the reviewer’s attention.
A. Representations and Warranties
Some agreements contain warranties stating that the bank is a duly
organized banking association, that there has been no material adverse
change in its condition since the date of the agreement and is not in
default on any agreement or in violation of its charter or bylaws.
Special attention should be given to a warranty or representation of the
bank that it is a national banking association. This is because, technically
speaking, the bank has not given itself the legal option of converting to a
state bank without violating the warranty or representation, and hence, the
agreement. The reviewer should ensure that any representations or
warranties of the bank’s corporate status are worded flexibly to avoid the
operation of any default clause should a change in corporate status occur.

B. Subordination Provision
The subordination provision is the heart of the note. Two questions have
arisen about this provision:
1.

May a note be secured by the bank’s assets via a sinking fund
arrangement or otherwise? The answer is NO. If the notes are
secured, the proceeds from the sale of the assets securing the
loan, in the event of insolvency, would be applied to the
obligations of the purchaser-noteholder. The notes would
clearly be, in effect, senior in right of payment to other
creditors.

2.

Must the note be subordinate only to the claims of depositors
or, in addition, be subordinate to the obligations of the Federal
Reserve, FDIC, and other creditors? Because these notes are
considered as capital, the OCC will require that they be
subordinate to the obligations of all creditors, except those
specifically designated as ranking on a parity with, or
subordinated to, the note. By their nature, subordinated notes
must be subordinate to all but equity accounts.

Every subordinated note must include the model subordination clause (or
substantially similar language) set forth in the Sample Subordinated Note
found later in this Appendix.

C. Acceleration Clauses
Formerly the OCC required that no payment due to acceleration could be
paid without its prior approval. This requirement had to be disclosed to
potential buyers of the subordinated debt. Effective with the July 1, 1995,
12

changes to 12 CFR 5, prior OCC approval of accelerated payments is no
longer required, except when the subordinated debt is intended to qualify
as Tier 3 capital. A bank that is healthy when issuing subordinated debt,
however, may deteriorate in condition. The OCC may, under the
authority in 12 CFR 5, require that any prepayment of outstanding
subordinated debt be made only with the OCC’s prior approval.
Consequently, banks issuing subordinated debt that either have been
informed that prior approval of the issuance or prepayment (including
payments under acceleration clauses) of the subordinated debt requires
prior OCC approval or intend the subordinated debt to qualify as Tier 3
capital must disclose this on the subordinated note. Other banks issuing
subordinated debt must disclose in the note that the OCC reserves the
authority, pursuant to 12 CFR 5, to require that prepayments (including
any to be made under an acceleration clause) receive OCC’s prior
approval before being made.

D. Affirmative Covenants
In an affirmative covenant, a bank promises to perform certain actions. Its
failure to do so may constitute an event of default. Generally, a bank
may enter into any type of agreement as long as it does not violate a law,
regulation, or OCC policy. The reviewer should closely examine those
covenants, which may restrict the bank’s operations abnormally or
require it to violate a law, regulation, or OCC policy. Some areas of
concern include:
1.

Availability of Financial Statements and Correspondence
The OCC will not object to a clause permitting the purchaser to
inspect the books and correspondence of the bank. However, the
bank should never allow confidential correspondence or reports of
supervisory activity (or parts thereof) to be made available or
otherwise disclosed, unless directed by the OCC pursuant to 12 CFR
4, Subpart C.
Financial statements may not be furnished prior to the date that they
would be filed with the OCC. Quarterly statements should be
provided within 45 days after the end of the quarter and yearly ones,
within 90 days after the end of the year.

2.

Disclosure of Classified Assets
Disclosure of any information contained in a bank’s report of
examination would violate confidentiality restrictions under which the
report is provided to the bank. The bank, however, may agree to
disclose any information derived from its system of internal audits or
otherwise and may disclose information that is publicly available,
such as the allowance for possible loan losses.

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3.

Compensating Balances
The OCC discourages the use of compensating balances, because of
the potential for placing the note purchaser in a secured position.
These arrangements are rare; but if compensating balances exist, they
should be scrutinized closely to prevent any possible creation of a
special fund earmarked for the repayment of the note, which would
elevate the purchaser to a secured position. The right to offset the
debt against any compensating balance is strictly prohibited.
Compensating balances are discouraged for several reasons. The cost
of funds is no longer clear-cut. The cost of maintaining a balance
would not be tax deductible, and the bank loses the use of funds
indicated on its balance sheet. The practice of selling subordinated
notes to correspondent banks clouds the issue, as it may be difficult to
differentiate between the normal or required correspondent balance.

E. Negative Covenants
In a negative covenant, a bank promises to refrain from performing certain
actions, or agrees that the occurrence of a certain event will give rise to
default. Since purchasers are intent on obtaining a maximum degree of
security, they often attempt to restrict the bank from engaging in certain
risky activities. The OCC discourages any provisions that unreasonably
impair the bank’s flexibility in conducting its operations. It also
disapproves of any undue interference with management that could result
in unsafe or unsound banking practices.
1.

Maintenance Ratios as an Event of Default
Some purchasers have proposed negative covenants that would
require the bank to maintain certain minimum amounts in its capital
accounts, or minimum capital to assets, liquidity, or loan ratios.
These types of maintenance ratios do not provide the notes with a
sufficient degree of permanence or stability. If this arrangement were
accepted, notes would be subject to acceleration if the bank
experienced short-term financial difficulties beyond its control.
Representations by the bank that its capital ratios are at specific levels
as of the date of the note are acceptable, provided that they do not,
directly or indirectly, constitute maintenance ratios.

2.

Restrictions on Additional Debt
Any proposal to restrict the issuance of additional debt should be
scrutinized on a case-by-case basis. Such limits may unduly restrict
the bank’s ability to raise additional capital through the issuance of
subordinated debt.
On occasion, a purchaser has proposed that any notes issued by the
bank in the future be junior in right of payment to the current issue.
This restriction is not allowed. The bank should be capable of issuing
notes that will rank on a parity with the current issue. The rationale is
14

that if future issues were required to rank junior to the present issue,
the bank might find it difficult to sell notes to maintain an adequate
capital base.
3.

Change of Control or Merger
Some purchasers have insisted on provisions that would allow a
change in control or merger to constitute a default. The OCC does
not allow the sale of stock at the direction of the Comptroller, which
results in a change in control, to constitute a default. In practice, the
OCC requires the purchaser of the bank to assume the obligation on
the subordinated debt. Therefore, the note holder would be
adequately protected.
OCC policy also provides that voluntary or involuntary mergers
should be allowed without triggering a default, if the resulting
institution: (a) is a commercial bank; (b) assumes the due and
punctual performance of all conditions of the note and agreement;
and, (c) is not in default of the various covenants. The OCC will not
permit a provision that requires the bank to obtain the purchaser’s or
holder’s approval prior to entering into a merger agreement.

4.

Subsidiaries
Questions have been raised as to whether an action (for example, a
default) by a subsidiary may trigger an acceleration of the note. The
answer is NO. The OCC does not allow a default by a subsidiary to
constitute a default by the bank, absent a separate agreement between
the subsidiary and the purchasers that is also to be reviewed and
approved by the OCC.

5.

Restrictions on Dividends
The OCC does not permit a purchaser to restrict the payment of cash
dividends because such dividend restrictions may be construed as the
creation of a sinking fund to protect an unsecured creditor of the
bank.

6.

Defaults
The holder of any subordinated note may, at its option, declare the
note to be due and payable when certain covenants have been
violated. The following are some events of default:
a.

Nonpayment of the interest and/or principal when due after a
15-day grace period.

b.

Nonpayment of borrowed money or failure to satisfy a final
judgment if either the nonpayment of borrowed money or the
failure to satisfy a final judgment is in excess of 5 percent of
the bank’s capital or $250,000, whichever is greater.

c.

Admission by the bank in writing of its inability to pay its debts
15

or the filing of a petition under applicable insolvency or
reorganization statutes.
d.

Consent to or appointment of a conservator or liquidator in any
insolvency, readjustment of debts, or marshaling of assets.

e.

Default in performance or observance of certain other
covenants after a prescribed grace period has expired.
When a default has occurred and is continuing, the registered
owner of any note may, at his/her discretion, by notice in
writing to the bank, declare the principal amount and any
accrued interest on any note in default to be immediately due
and payable. A declaration by the registered owner or owners
of at least 25 percent in principal amount of the notes
outstanding will cause the unpaid principal of all the notes
outstanding together with the interest accrued to become due
and payable.
As a matter of policy, the OCC prefers events of default that
provide for a reasonable period to ”cure” the default, if
possible.

F. Transfer at OCC Direction
The OCC also requires the insertion of certain (or substantially similar)
language to permit a bank to merge or follow any plan of reorganization
or liquidation designed to protect or further the continued existence of the
bank. This language (reproduced in the Sample Subordinated Note found
later in this Appendix) supersedes and voids any defaults that would have
resulted from the breach of the various covenants. It specifically
authorizes the OCC (or its appointed agent) to transfer the note to any
banking entity that agrees to assume its obligations of the note.

G. Contemporaneous Loan Agreements
The OCC has found, on occasion, that a bank holding company or other
note purchaser will ”fund” the injection of subordinated debt into a
national bank by a contemporaneous loan agreement with a third-party
lender. The terms and conditions of these loan agreements often, by their
language, place significant, and unacceptable, restrictions on the
operations of the bank raising subordinated debt. Accordingly, it is
important to determine, in all instances, whether such a third-party loan
agreement exists and, if it does, to review that agreement for compliance
with the requirements and policies discussed here.

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H. Novel or Extraordinary Provisions
These discussions will address most of the questions encountered in a
routine review. However, sometimes, novel and untested proposals will
be presented. Such proposals and those that raise policy concerns should
be referred to the OCC’s Bank Supervision Policy Department for review
and final disposition.

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Appendix B: Sample Subordinated Note
THIS OBLIGATION IS NOT A DEPOSIT AND IS NOT INSURED BY THE FEDERAL
DEPOSIT INSURANCE CORPORATION. THIS OBLIGATION IS SUBORDINATED
TO THE CLAIMS OF DEPOSITORS, IS INELIGIBLE AS COLLATERAL FOR A LOAN
BY THE BANK, AND IS NOT SECURED.

Date: ___________________

$

NOTE: The first two paragraphs apply to a subordinated note. Paragraphs three
through six apply to a mandatory convertible note. The remaining paragraphs
apply to both a subordinated note and a mandatory convertible note.
[Subordinated Note]
(bank name)
, a national banking association,
promises to pay to the order of
(the purchaser), at the
purchaser’s offices in
in lawful money of the United States of
America, the principal amount of $
, together with interest on the part of the
principal amount from time to time remaining unpaid from this date until such
principal is paid at the rate of __ percent per annum.
The entire unpaid principal of this note and any accrued interest then unpaid shall
be due and payable on or before _____
. The interest on this note shall be
due and payable semiannually as it accrues on the first day of each ___
and
until this note is paid in full, commencing on the first such day next
succeeding this date. The bank shall have the right and privilege of prepaying all or
any part of this note at any time without notice or penalty, subject to OCC approval,
and all payments on this note shall be applied first to accrued interest and the
balance, if any, to principal.
[Mandatory Convertible Note]
(bank name)
, a national banking association, promises to pay to
the order of
the (purchaser) the principal amount of $ ________
on ___________, through the exchange of capital stock with a (method of
determining value) value equal to the principal sum.
The bank promises to pay to the order of
(the purchaser) at the
in lawful money of the United States of
purchaser’s offices in
America, interest on the principal amount of $
, at the rate of

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percent per annum from
until maturity. Interest is due and
payable semiannually as it accrues on the last business day of
and
in each year commencing
and at maturity.
The bank represents and warrants that all capital stock issued in exchange for the
note will upon issuance be duly and validly authorized and issued and fully paid
and (except as provided in 12 USC 55) non-assessable.
No fractional shares of capital stock will be issued in exchange for the note. In lieu
of issuing any fractional shares, the bank shall pay a cash adjustment for such
fraction in an amount equal to the same fraction of the (method of determining
value) value of one share of capital stock.
[Subordinated Note/Mandatory Convertible Note]
The indebtedness of the bank evidenced by this note, including the principal and
premium, if any, and interest shall be subordinate and junior in right of payment to
its obligations to its depositors, its obligations under bankers’ acceptances and
letters of credit, and its obligations to its other creditors, including its obligations to
the Federal Reserve Bank, Federal Deposit Insurance Corporation (FDIC), and any
rights acquired by the FDIC as a result of loans made by the FDIC to the bank or the
purchase or guarantee of any of its assets by the FDIC pursuant to the provisions of
12 USC 1823(c), (d) or (e), whether now outstanding or hereafter incurred. In the
event of any insolvency, receivership, conservatorship, reorganization, readjustment
of debt, marshaling of assets and liabilities or similar proceedings or any liquidation
or winding up of or relating to the bank, whether voluntary or involuntary, all such
obligations shall be entitled to be paid in full before any payment shall be made on
account of the principal of, or premium, if any, or interest, on the note. In the event
of any such proceedings, after payment in full of all sums owing on such prior
obligations, the holder, of the note, together with any obligations of the bank
ranking on a parity with the note, shall be entitled to be paid from the remaining
assets of the bank the unpaid principal thereof and any unpaid premium, if any, and
interest before any payment or other distribution, whether in cash, property, or
otherwise, shall be made on account of any capital stock or any obligations of the
bank ranking junior to the notes. Nothing herein shall impair the obligation of the
bank, which is absolute and unconditional, to pay the principal of and any premium
and interest on the note according to its terms. This note shall become immediately
due and payable, at the option of the holder, without presentment or demand or
any notice to the bank or any other person obligated, (i) upon default in the
payment of any of the principal or interest, for a period of 15 days after such
payment is due; (ii) upon default (a) in the payment of any of the principal of or
interest on any other indebtedness of the bank for borrowed money owing from the
bank to the purchaser, or (b) in the payment of any other material indebtedness for
borrowed money and, in either event, the continuance of such default beyond any
period of grace provided for in the instrument or instruments evidencing such
indebtedness.
The bank waives demand, presentment for payment, notice of nonpayment, notice
of protest, and all other notices.
Notwithstanding any other provisions of this note, including specifically those set
forth in the sections relating to subordination, events of default and covenants of the
bank, it is expressly understood and agreed that the Office of the Comptroller of the
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Currency (OCC) or any receiver or conservator of the bank appointed by the OCC
shall have the right in the performance of his legal duties, and as part of liquidation
designed to protect or further the continued existence of the bank or the rights of
any parties or agencies with an interest in, or claim against, the bank or its assets, to
transfer or direct the transfer of the obligations of this note to any bank or bank
holding company selected by such official which shall expressly assume the
obligation of the due and punctual payment of the unpaid principal, and interest
and premium, if any, on this note and the due and punctual performance of all
covenants and conditions; and the completion of such transfer and assumption shall
serve to supersede and void any default, acceleration or subordination which may
have occurred, or which may occur due or related to such transaction, plan, transfer
or assumption, pursuant to the provisions of this note, and shall serve to return the
holder to the same position, other than for substitution of the obligor, it would have
occupied had no default, acceleration or subordination occurred; except that any
interest and principal previously due, other than by reason of acceleration, and not
paid shall, in the absence of a contrary agreement by the holder of this note, be
deemed to be immediately due and payable as of the date of such transfer and
assumption, together with the interest from its original due date at the rate provided
for herein.
By:

____________________________________________

Name: ___________________________________________
Title: _____________________________________________

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Glossary
A capital plan is a proposal that describes the means and schedule by which a
national bank will attain specified capital levels or ratios, including a plan to
achieve minimum capital ratios, filed with the OCC under 12 CFR 3.7, or
a capital restoration plan filed with the OCC under 12 USC 1831o and
12 CFR 6.5.
Perpetual preferred stock means preferred stock that does not have a stated
maturity date and cannot be redeemed at the option of the holder.
Tier 2 capital has the same meaning as in 12 CFR 3.2(d).
Tier 3 capital has the same meaning as in 12 CFR 3, Appendix B, section 2(d).
An eligible bank is a national bank that:
•

Has a composite CAMELS rating of 1 or 2.

•

Has an ”outstanding” or ”satisfactory” Community Reinvestment Act (CRA)
rating. (This does not apply to an uninsured bank or branch or a special-purpose
bank covered by 12 CFR 25.11(c)(3).)

•

Is well capitalized as defined at 12 CFR 6.4(b)(1).

•

Is not subject to a cease and desist order, consent order, formal written
agreement, or prompt corrective action directive or, if subject to any such order,
agreement or directive, is informed in writing by the OCC that the bank may be
treated as an ”eligible bank.”

21

References
Capital Deficiency
Law

12 USC 55

Capital Definition
Regulation

12 CFR 3

Capital Requirements and Minimum Ratios
Law
Regulation

12 USC 3907
12 CFR 3

Filing Fees
Regulation

12 CFR 5.5

Impairment
Laws

12 USC 51b-1, 56

Legal Lending Limit Calculation
Law
Regulation

12 USC 84
12 CFR 32.4

Mandatory Convertible Debt
Regulation

12 CFR 3.100(e)(5)

Perpetual Preferred Stock
Regulation

12 CFR 3.100(e)(8)

Prompt Corrective Action
Law
Regulation

12 USC 1831o
12 CFR 6

Reduction of Capital
Law
Regulation
Securities Offering Disclosures Rules
Regulation

12 USC 59
12 CFR 5.46
12 CFR 16

Subordinated Debt as Capital
Regulation

12 CFR 5.47

22