Fed OKs Rule to Restrict Use of ‘Junk Bonds’ : 3-2 Vote Goes Against Administration’s Stand

The Federal Reserve Board on Wednesday narrowly approved a controversial new rule, opposed by the Reagan Administration, that restricts the use of high-risk, high-interest “junk bonds” to finance a limited range of corporate takeovers.

The board split 3 to 2 on the measure, with the two Fed governors appointed by President Reagan opposing it and Chairman Paul A. Volcker and two holdover governors supporting it.

The new rule, which applies to merger credit agreements entered into after Jan. 8, prohibits “shell corporations” set up expressly for the purpose of taking over another company from financing more than 50% of an acquisition with bonds backed only by the still-to-be-acquired stock of the target company.

But the Fed’s decision was substantially narrower than its original proposal of last month.

Exempts Operating Companies

The Administration had sharply criticized that approach as an improper expansion of Fed authority and an unnecessary and costly regulatory intrusion into the marketplace.

As now written, the restriction applies only to shell corporations with no assets or operations. It explicitly exempts operating companies, shell corporations whose debt instruments are backed by an operating company or “friendly” merger cases in which the debt is all but certain to be secured by the target company’s assets.

Assistant Atty. Gen. Douglas H. Ginsburg, head of the Justice Department’s antitrust division, sent the Fed a letter Tuesday acknowledging the narrower scope of the final rules but restating the Administration’s unhappiness with any expanded regulation of the securities market.

After the Fed acted, Charles F. Rule, Ginsburg’s chief deputy on the junk bond issue, said: “We are gratified that the Fed has responded to some of our suggestions and has limited their interpretation” of longstanding margin requirements designed to limit unsecured investment risk. “They have made it clear the new restriction does not apply to operating companies and that it does not apply to debt that is part of a public (stock) offering,” Rule said.

“On the other hand,” Rule added, “we still have serious problems with what the Fed did. Nowhere do they justify it in policy terms, in terms of costs and benefits. While they are not applying this to all shells and exempt some leveraged buy-outs and friendly deals, that only accentuates its application to hostile takeovers.”

In his original Dec. 23 brief opposing Fed action, Ginsburg argued that successful hostile takeovers that are ratified by the marketplace improve corporate efficiency and benefit the U.S. economy in the long run.

Fed Vice Chairman Preston Martin and board member Martha Seger, both Reagan appointees, opposed the new regulation even in its more limited form. Volcker, J. Charles Partee and Emmett Rice supported it. Henry Wallich, who has recently returned to work after an illness, did not vote, and the seventh board seat is vacant.

At an open meeting of the board, Volcker stressed the narrow scope of the Fed’s action and presented it primarily as a long-overdue clarification of existing Fed rules, which impose a 50% margin requirement on those who buy stock in the marketplace.

By the board’s definition, the 50% margin rule for junk bond financing would apply only to shell corporations that “would have (1) virtually no operations; (2) no significant business function other than to acquire and hold the margin stock of the target company, and (3) substantially no assets or cash flow to support credit extended to it other than the margin stock that it has acquired or intends to acquire.”