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FARM CREDIT ADMINISTRATION

Farm Credit Administration

CFR Citation: 12 CFR Part 615

RIN ID: RIN 3052-AC42

NOTICE: PROPOSED RULES

ACTION: Funding and Fiscal Affairs; Loan Policies and Operations:

DOCUMENT ACTION: Proposed rule.

SUBJECT CATEGORY: Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; Mission-Related Investments, Rural Community Investments

DATES: Comments should be received on or before August 15, 2008.

DOCUMENT SUMMARY: The Farm Credit Administration (FCA) proposes a new rule that would authorize each Farm Credit System (Farm Credit, System, or FCS) bank, association, and service corporation (institution) to invest in rural communities across America under certain conditions. The proposed rule would allow each System institution to make investments in rural communities that are outside of an urbanized area only for specific purposes. Several provisions in the proposed rule would ensure that System investments in rural America are safe and sound and comply with the Farm Credit Act of 1971, as amended (Act), and other applicable statutes.

SUMMARY: Funding Operations; Mission-Related Investments, etc.,

SUPPLEMENTAL INFORMATION

I. Background

The FCA proposes a new rule, Sec. 615.5176, which would enable System institutions to more effectively serve the needs of rural communities by exercising investment powers under the Act. The proposed rule focuses on specific needs in rural communities. Essentially, the proposed rule would authorize two separate types of investments that System institutions could make in America's rural communities. First, System institutions could invest in debt securities that would involve projects or programs that benefit the public in rural communities. Equity investments in venture capital funds are the second type of investment that the proposed rule would authorize. Venture capital funds create new economic opportunities and jobs in rural communities by providing capital to small or startup businesses.

The proposed rule would authorize each System institution to make investments in rural areas that according to the terms of the latest United States decennial census have fewer than 50,000 residents and are outside of an urbanized area. The proposed rule would allow System institutions to invest in: (1) Essential community facilities; (2) basic transportation infrastructure; (3) rural communities recovering from disasters; (4) debt securities for rural development projects that the United States, its agencies, any state, Puerto Rico, or a local municipal government sponsors or guarantees; (5) debt securities that support the rural development activities of nonSystem financial institutions; (6) rural business investment companies; and (7) venture capital funds that invest in rural businesses that create jobs and economic growth under specific conditions. The proposed rule also would allow System institutions to make other investments that are not expressly covered by this regulation with FCA approval. Under the proposed rule, an institution may hold rural community investments in an amount that does not exceed 150 percent of its total surplus. As discussed in greater detail below, other provisions of the proposed rule address safety and soundness and compliance with the Act. A. The Statutory Basis for the Proposed Rule

System institutions derive their investment authorities from several provisions of the Act. Sections 1.5(15) and 3.1(13)(A) of the Act \1\ authorize System banks to invest in securities of the United States and its agencies, and make ``other investments as may be authorized under regulations issued by the Farm Credit
Administration.'' Sections 2.2(10) and 2.12(18) of the Act \2\ authorize System associations to invest their funds as approved by their district banks in accordance with FCA regulations. A System service corporation is authorized by section 4.25 of the Act \3\ to engage in investment activities to the same extent as its System parents.\4\
\1\ 12 U.S.C. 2013 (15) and 2122 (13)(A).
\2\ 12 U.S.C. 2073 (10) and 2093 (18).
\3\ 12 U.S.C. 2211. Section 4.25 authorizes System banks to organize service corporations. Section 4.28A of the Act, 12 U.S.C. 2214a, confers this authority on System associations.
\4\ Section 4.25 of the Act prohibits service corporations from extending credit or providing insurance services to System borrowers. Otherwise, the Act authorizes service corporations to perform any other function or service that its FCS parents may perform. Service corporations currently have authority to purchase and hold other investments under FCA regulations in subpart E of part 615.

Investments in rural communities are compatible with the System's statutory mandate. The preamble to the Act clearly states that Congress enacted the law ``to provide for an adequate and flexible flow of money into rural areas, and to modernize * * * existing farm credit law to meet current and future rural credit needs, and for other purposes.'' The preamble and investment provisions of the Act form a broad statutory framework that confers considerable discretion on the FCA to decide the purposes, conditions, and limits for all investment activities at System institutions. In exercising this discretion, the FCA has authorized System institutions to invest their funds in obligations that are suitable for liquidity, risk management, and activities that are closely related to the System's statutory mandate.

In implementing the investment provisions of the Act, the FCA has taken a cautious and incremental approach in approving System investments for missionrelated purposes. Since Congress enacted the Act in 1971, the FCA has approved new regulations and programs that authorize the System to make specified investments in agriculture and rural communities, subject to certain conditions and limits. The factors that the FCA considers whenever it decides to approve new missionrelated investments are: (1) The financial needs of agriculture and rural communities; (2) new investment products offered in the marketplace; (3) the System's status as a Governmentsponsored enterprise (GSE); and (4) compliance with the Act and other applicable statutes. Under FCA regulations and programs, System investments in agriculture and rural communities have remained small because lending to farmers, ranchers, cooperatives, and other eligible borrowers is the primary activity of System institutions under the Act. Additionally, most missionrelated investments that the FCA has approved are related to the System's expertise in financing agriculture, rural housing, and infrastructure in rural areas.

Historically, the FCA has authorized System institutions to invest in debt securities, but not in equity securities of nonSystem entities. In 2002, Congress granted System institutions express authority to invest in rural business investment companies (RBICs), which are venture capital funds that the United States Department of Agriculture (USDA) funds and oversees. The FCA believes that allowing the System to invest in venture capital funds that hold small equity positions in startup rural enterprises is consistent with
congressional intent. As discussed in greater detail below, the proposed rule would implement the provisions of title VI of the Farm Security and Rural Investment Act of the 2002 \5\ and the Act by allowing System institutions to invest in RBICs and other venture [[Page 33933]]
capital funds that provide startup money to rural entrepreneurs. \5\ Pub. L. No. 107171, Sec. 384J, 116 Stat. 134, 397 (May 13, 2002).

In accordance with the Act, the FCA has enacted several regulations since 1971 that authorize System investments in agriculture and America's rural communities. The first missionrelated investments that the FCA approved were farmers' notes.\6\ Since 1972, FCA regulations have authorized System banks and associations to invest in obligations of States, municipalities, and local governments. In 1993, a new regulation authorized System institutions to purchase and hold mortgage securities issued or guaranteed by the Federal Agricultural Mortgage Corporation (Farmer Mac). In 1999, the FCA amended another regulation to permit investment in asset securities backed by agricultural equipment. An existing regulation, Sec. 615.5140(e), allows Farm Credit institutions to hold other investments that the FCA approves on a casebycase basis. This regulatory framework guides investment practices at Farm Credit institutions and ensures that System investments comply with law and are safe and sound.
\6\ The farmers' note program authorizes production credit associations and agricultural credit associations to invest in notes, contracts, and other obligations farmers and ranchers enter into with cooperatives and dealers that sell farm equipment, inputs, and supplies. Farmers' notes are investments that provide liquidity to small rural agribusinesses.

Since 2005, the FCA has approved requests by System banks and associations, on a casebycase basis, to initiate pilot programs for investing in America's rural communities under specified conditions. Under these FCAapproved pilot programs, System institutions acquired expertise and became active in making investments that provided funding for essential projects in rural communities.

Based on the positive experience of these pilot programs, the FCA is proposing a rule that will allow all System banks, associations, and service corporations to make certain investments in rural communities under prescribed conditions without prior FCA approval. This proposed rule would permit the ruralbased System to use its expertise and a portion of its financial resources to support rural economic growth and development by investing in those projects and programs in America's rural communities that often have difficulty attracting financing at affordable rates.

The proposed rule implements the investment provisions of the Act by ensuring that: (1) System institutions invest in rural communities only for specific purposes; and (2) all instruments purchased and held by Farm Credit institutions are investment securities in accordance with market practices and securities laws. Investments in rural communities also would be subject to a portfolio limit and other controls to ensure that FCS rural community investment activities comply with the Act and are safe and sound.

The FCA emphasizes that lending to farmers, ranchers, aquatic producers and harvesters, farmrelated businesses, rural homeowners, cooperatives, and rural utilities remains the primary purpose of the System. However, within the parameters prescribed by the proposed rule, System investments, which help strengthen the economic viability of rural communities, are compatible with the preamble and several provisions of the Act. Investing in rural communities enables Farm Credit to fulfill its mission by helping sustain rural communities on which the System's borrowers and owners are dependent for their livelihoods.

B. Why Investments in Rural Communities Are Important

The FCA proposes this rule to allow the System to make investments in rural communities and to support and supplement investments by government, commercial banks, investment banks, and venture capital funds. The FCA believes that this new rule will enable the System to more fully assist rural communities in financing projects that are designed to provide essential facilities, infrastructure, and services to residents. As discussed in greater detail below, System institutions made investments under FCA authorized pilot programs, which demonstrated that the FCS is both locally and regionally positioned to effectively participate and assist rural development networks that strive to address rural needs. The proposed rule is designed to enable FCS institutions to collaborate and partner in rural development initiatives that advance the System's mission and its capacity to serve as a financial intermediary promoting the flow of money into rural areas.

Many rural communities are struggling to retain economic viability and vitality that can provide economic opportunities and a better quality of life for their residents. Rural communities face numerous demographic, social, and economic challenges in meeting the needs of their residents. As a result, rural communities often find it difficult to provide the essential facilities, infrastructure, and services that their residents need. For example, an aging population in rural areas requires medical and assisted health care facilities. However, rural communities often have fewer health care providers and facilities to meet the increasing medical needs of its growing elderly population.\7\ \7\ Carol A. Jones, et al., ``Population Dynamics Are Changing the Profile of Rural Areas,'' Amber Waves, Economic Research Service, United States Department of Agriculture, April 2007, p. 5.

Also, a large gap persists between rural and metropolitan residents who have earned college degrees. This gap is reinforced by a lower demand for workers with postsecondary degrees in rural areas, which in turn, contributes to the outmigration of skilled workers.\8\ These factors place rural communities at a disadvantage in attracting businesses that offer higher wages and better job benefits to employees. Essential facilities, infrastructure, and services in rural areas often lag behind those in metropolitan areas. This is another factor that limits the ability of rural communities to attract and retain businesses that provide employment and economic opportunities. These obstacles to rural economic development and revitalization are further compounded by funding challenges for projects that are designed to assist rural communities in resolving these problems.
\8\ ``Rural Education At A Glance,'' Rural Development Research Report Number 98, Economic Research Service, United States Department of Agriculture, November 2003, p. 4.

Funding for economic growth and development projects in rural communities is available from a variety of sources, most notably the Federal and State governments, and privatesector financiers, including commercial and investment banks. Each of these entities faces challenges in providing rural communities with the funding needed for these projects. Efforts by Federal or State governments to help rural communities are often curtailed by budget constraints. Also, many rural community banks are willing to provide shortterm funding, but find it difficult to provide the additional longterm capital investment needed for facilities in rural areas.\9\ Essential facilities and large capital improvements, such as critical care access hospitals, require a large capital investment that is repaid over an extended period of time. In many cases, no single investor is willing and able to supply all of the capital necessary for such projects, and rural
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communities must depend on a combination of government and private sector financial sources and local donations.\10\ Another obstacle is that rural development projects in remote rural locations typically involve higher costs and greater risks, which deter investors. For these reasons, government and privatesector financial resources often are insufficient to fully fund many necessary and worthwhile projects that rural residents need.
\9\ Walter Gregg, The Availability and Use of Capital by Critical Access Hospitals, Flex Monitoring Team Briefing Paper No. 4, Flex Monitoring TeamUniversity of Minnesota, University of North Carolina at Chapel Hill, and the University of Southern Maine, March 2005, p. 10.

\10\ Ibid., p. 25 and 26.

System institutions are an integral part of rural America. The farmers and ranchers who borrow from and own the FCS live and work in rural communities. These System stockholders and their families depend on local rural communities for essential services, employment, and other economic opportunities. Today, the majority of farm household income is derived from offfarm sources.\11\ As a result, farm families depend on local rural communities for employment that supplements farm income. Further, agricultural production is one of the most hazardous industrial sectors.\12\ Farmers and ranchers confront the same problems as other residents of America's rural communities in obtaining access to quality hospitals, medical facilities, schools and essential services.
\11\ Ted Covey, et al., ``Agricultural Income and Finance Outlook,'' Outlook, AIS85, Economic Research Service, United States Department of Agriculture, December 2007, p. 49.
\12\ ``Chapter 3Focus on Agriculture,'' Worker Health Chartbook 2004, National Institute for Occupational Safety and Health, NIOSH Publication No. 2004146, p. 1.

System institutions are active in financial markets that serve regional and local rural areas across the United States. For this reason, the System is familiar with the challenges that rural communities face in meeting the needs of both farm and nonfarm rural residents. The System has the financial capacity to invest in rural development, and this proposed rule would advance the System's contributions to rural development efforts.
C. Investments in Rural Communities Made Under Pilot Programs

Over the past 3 years, a number of System institutions have developed programs to make investments in rural communities through FCAapproved pilot programs. As a result of the investments made under these pilot programs, rural communities were able to address specific regional needs because these investments provided greater access to capital for community facilities, revitalization projects, and other economic development initiatives. These investments also provided additional liquidity into rural financial markets. In several cases, these investments helped provide capital at more affordable terms and rates, which in turn made these projects more feasible.

The pilot programs have demonstrated that Farm Credit institutions have the capacity and willingness to work collaboratively with rural communities and financial institutions to address local and regional rural economic development needs. As previously discussed, many rural development projects are reliant on multiple partners for success. In making rural community investments under the pilot programs, System institutions partnered with: Federal, State, and regional rural development authorities; nonSystem financial institutions including rural community banks; nonprofit organizations; and venture capital funds. For example, System investments under the pilot programs have provided capital for rural hospitals designated as critical access facilities, which were sponsored, in part, by the USDA's Rural Development Community Facilities Program. Other examples of specific System investments that have made a positive difference in rural communities include investments in: Medical and mental clinics; treatment facilities for adolescents and adults; living and nursing centers for the elderly; schools; and community facilities. Several projects, which were sponsored by regional or State development authorities, modernized obsolete facilities for valueadded agricultural products, or created new facilities to promote local economic growth. These projects were designed to promote economic growth in rural areas by attracting and promoting businesses that create or retain jobs in these rural communities.

NonSystem financial institutions and venture capital funds have also benefited from investments that System institutions made under the pilot programs. For example, System institutions have helped to increase liquidity at several rural community banks by buying bonds that support the rural development efforts of these banks. These investments enabled these banks to reduce the longterm financing costs for specific rural development projects. Additionally, investments in regional investment networks provided venture capital to rural entrepreneurs for startup businesses that contributed to the vitality of rural communities. System institutions were prudent in undertaking investment activities in rural communities and assumed reasonable risks within pilot program conditions.

In addition to the pilot programs, grant programs and charitable contributions at many System institutions complement their commitments to the citizens of local rural communities. Although the proposed rule does not specifically address grants, System institutions have authority under the incidental power provisions of the Act to make charitable grants and donations.\13\ The FCA continues to encourage FCS institutions to consider making charitable donations and contributions to worthwhile causes in the communities they serve. System institutions have contributed to a wide variety of community organizations and entities, including emergency and medical services, agricultural and rural community development educational programs, and valueadded agricultural product initiatives. Charitable grants by System institutions complement rural community investment programs and are an additional way for Farm Credit institutions to further the System's mission and help enhance the quality of life for residents in rural communities.
\13\ Sections 1.5 (21), 2.2 (20), 2.12 (20) and 3.1 (16) of the Farm Credit Act (12 U.S.C. 2013 (21), 2073 (20), 2093 (20), 2122 (16)).
II. SectionbySection Analysis

A. Rural Communities

Proposed Sec. 615.5176(a) would authorize Farm Credit banks, associations, and service corporations to make rural community investments. Proposed Sec. 615.5176(a) also provides that FCS institutions may make these investments only in areas outside of an ``urbanized area'' \14\ as defined by the latest decennial census of the United States. For the purposes of this proposed rule, areas outside of an urbanized area are ``rural.'' The proposed rule would authorize the FCS to make rural community investments in areas that the United States Census Bureau determined in the latest decennial census to have a population of less than 50,000 residents. For the purposes under this proposed rule, the geographic area includes any State within the United States and the Commonwealth of Puerto Rico.
\14\ The United States Census Bureau defines an urbanized area as an urban area of 50,000 or more people that have core census block groups or blocks that have a population density of at least 1,000 people per square mile and surrounding census blocks that have an overall density of at least 500 people per square mile.

The FCA considered numerous definitions of ``rural,'' recognizing there is no single, universally preferred
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definition of ``rural'' that policymakers commonly use.\15\ In fact, more than 15 definitions of ``rural'' are currently used by different Federal agencies for various programs.\16\ In developing the proposed rule, the FCA relied on Census Bureau terminology to ensure that the geographic areas in which investments are permitted are readily identifiable and easily distinguished.

In determining which geographic areas should qualify under the proposed rule, the FCA seeks to include those areas with sufficient population densities to support health care and other essential facilities serving rural residents, while prohibiting investments in urbanized areas. For example, hospitals and other health care facilities that primarily serve rural geographic areas are typically located in areas that have less than 50,000 residents. Also, whenever Congress has expressly authorized FCS institutions to lend or invest in rural development projects, it has allowed these activities in communities with populations of 50,000 or fewer residents.\17\ Additionally, most Federal agencies and demographic experts have determined that densely populated areas with 50,000 or more inhabitants are urbanized areas. For this reason, investments authorized under the proposed rule would allow System institutions to invest in areas with populations of less than 50,000 residents based on the latest decennial census of the United States.
\15\ Andrew F. Coburn et al., ``Choosing Rural Definitions: Implications for Health Policy,'' Rural Policy Research Institute Health Panel, March 2007, p. 1.
\16\ Ibid.
\17\ According to section 3.7(f) of the Act, 12 U.S.C. 2128(f), banks for cooperatives and agricultural credit banks may extend credit to water and waste disposal facilities in communities where the population does not exceed 20,000 inhabitants based on the latest decennial census of the United States. A provision of the Farm Security and Rural Investment Act of 2002, 7 U.S.C. 2009cc, et seq., authorizes System institutions to establish and invest in rural business investment companies in communities in non
metropolitan counties that have populations of 50,000 or less inhabitants under the last decennial census of the Unites States.

By allowing the System to invest in rural communities that have fewer than 50,000 residents, the proposed rule provides ``an adequate and flexible flow of funds into rural areas'' in accordance with the Act, while precluding System institutions from investing in urbanized areas. Information is publicly available on the Census Bureau's Web site, including census population statistics and maps. As a result, System institutions and other interested parties are able to determine if a particular location is within a ``rural'' community for the purposes of Sec. 615.5176(a).

B. Debt Securities

Proposed Sec. 615.5176(b) would authorize System institutions to invest in rural communities by purchasing and holding debt securities for purposes specified in Sec. 615.5176(b)(1) through (5). The proposed rule defines debt securities as obligations that are commonly recognized in capital markets as a medium for investment, including government obligations, corporate bonds, revenue bonds, assetbacked securities and mortgage securities. Proposed Sec. 615.5176(b) expressly excludes commercial loans and instruments or transactions that are more similar to commercial loans than to traditional investment instruments in order to clarify the statutory distinction between loans and investments. Under the proposed rule, System institutions could not use their authority to invest in rural communities to make loans to otherwise ineligible borrowers. 1. Essential Community Facilities

Proposed Sec. 615.5176(b)(1) would authorize System institutions to invest in debt securities that finance essential community facilities, such as hospitals, health care facilities, emergency services, and schools. Many essential community facilities are owned and operated by State, local, or municipal governments. In other cases, quasigovernmental or highly regulated private and nonprofit entities own and operate essential community facilities. Government obligations and revenue bonds often fund the construction and renovation of these facilities. Rural communities are currently facing increasing difficulty in funding these facilities because of deteriorating liquidity in financial markets. System institutions can help alleviate this problem by purchasing and holding debt securities as investments in community facilities that provide essential services to rural residents.

2. Basic Transportation Infrastructure

Financing basic transportation infrastructure, such as roads, bridges, and other public transportation systems, is another authorized investment purpose under the proposed rule. The public sector owns, maintains, and operates most basic transportation infrastructure in the United States. Most rural transportation facilities are operated by public agencies or nonprofit groups, with a small percentage operated by private entities. Transportation projects are another area where the System could significantly help rural communities build and improve infrastructure, which would strengthen their economic viability. Rural communities and particularly agricultural industries, depend on quality transportation systems, which are critical in supplying inputs, shipping and distributing outputs and products, and supporting economic development. Proposed Sec. 615.5176(b)(2) would authorize System institutions to purchase government obligations, revenue bonds, and other debt obligations that support basic transportation
infrastructure.

3. Revitalization of Rural Communities After a Disaster

Proposed Sec. 615.5176(b)(3) would permit System institutions to purchase debt securities in revitalization projects that help rebuild rural areas devastated by disasters where an emergency has been declared pursuant to law. These investments must support local efforts and residents by contributing to the economic recovery of the affected rural community.
4. Rural Development Projects With Government Sponsorship or Guarantees

Under proposed Sec. 615.5176(b)(4), System institutions could invest in debt securities that a government issues, sponsors, or guarantees under programs to fund rural community development projects. Without crucial financial support from Federal, State, or local governments, rural communities would face greater difficulty in funding vital development projects. By investing in debt securities for rural economic development under government programs, the System assists rural communities across America in accordance with its statutory mandate. By proposing Sec. 615.5176(b)(4), the FCA is encouraging System institutions to work with Federal, State, and local governments and their partners to invest in projects that bring jobs,
infrastructure, community facilities, and vital services to rural areas and their residents.

Proposed Sec. 615.5176(b)(4)(i) covers debt securities that the United States and its agencies issue, sponsor, or guarantee under programs that have the specific purpose of directly financing economic development in rural communities. The FCA emphasizes that the proposed rule does not require the full faith and credit of the United States for bonds issued or guaranteed by agencies of the United States. However, these investments are authorized only if the Federal agency issues or guarantees these bonds or obligations in accordance with a program that has the specific purpose of promoting economic development in rural areas. For
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example, the Tennessee Valley Authority, the Small Business Administration, and various agencies in the USDA and the Department of Housing and Urban Development issue and guarantee bonds under specific programs for infrastructure, facilities, and other development projects in rural areas, and System investment in these obligations would be authorized by the proposed rule.

Other Federal agencies operate programs in both metropolitan and rural areas which are not part of any specific rural development mission. Bonds and other obligations issued or guaranteed under such programs would not qualify as investments under the proposed rule. For example, the proposed rule would not authorize the FCS to invest in mortgage securities issued or guaranteed by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation because the purpose of these securities is to enhance the liquidity of residential home loans throughout the United States, rather than to promote rural development. Another regulation, Sec. 615.5140, permits System institutions to make investments for liquidity and risk management purposes in bonds and obligations, including residential mortgage securities, that Federal agencies issue or guarantee under programs that are unrelated to rural development. The proposed rule focuses on investments in rural communities and would not authorize System institutions to hold residential mortgage securities issued by other GSEs, but the FCA continues to study this issue.

Proposed Sec. 615.5176(b)(4)(ii) would allow System institutions to invest in debt securities that any State, the Commonwealth of Puerto Rico, a local or municipal government, or other political subdivision of a State, issues, sponsors, or guarantees that are specifically related to development in rural communities. Many local or municipal governments and other political subdivisions, such as special districts, often sponsor particular rural development projects by providing tax incentives or other benefits to privatesector obligors who issue revenue bonds. These revenue bonds, which help finance rural development projects, would qualify as investments that FCS institutions could purchase and hold under proposed Sec.
615.5176(b)(4)(ii). This provision would also allow System institutions to invest in mortgage securities that are issued or guaranteed by State or local agencies that specialize in rural development.
5. Rural Development Projects Financed by NonSystem Financial Institutions

Proposed Sec. 615.5176(b)(5) would allow System institutions to invest in debt securities issued by nonSystem financial institutions. The proposed rule would authorize System institutions to purchase these debt securities to increase financial assistance to rural communities and improve the liquidity of rural financial markets. This provision would enhance cooperation between System and nonSystem financial institutions and ultimately benefit rural communities. System institutions may purchase assetbacked securities, covered bonds, or similar types of bonds issued by nonSystem financial institutions directly or through trusts that supply funds to nonSystem financial institutions for rural development. Investments made under the pilot programs evidence that securities, including commercial bank bonds issued by rural community banks and purchased by System institutions, can effectively increase bank liquidity. These investments benefit rural communities and residents, while establishing partnerships between nonSystem and System institutions.

C. Equity Investments

Equity investments in venture capital funds are another type of investment that the proposed rule would authorize FCS institutions to purchase and hold. Under this provision of the proposed rule, System institutions could invest in venture capital funds that provide capital to startup and small privatesector enterprises that bring jobs and economic opportunities to rural communities. Venture capital funds that operate in the United States invest only 1.6 percent of their funds in rural community enterprises, although these enterprises represent 19.2 percent of all businesses.\18\ System institutions could make a small, but meaningful, contribution to rural economic development by investing in venture capital funds that provide capital into rural enterprises. As discussed in greater detail below, System institutions would hold only small, passive investment positions in venture capital funds because of statutory and regulatory restrictions.
\18\ Kendall McDaniel, ``Venturing into Rural America,'' The Main Street Economist, Center for the Study of Rural America Federal Reserve Bank of Kansas City, p. 2.

Proposed Sec. 615.5176(c) would authorize System institutions to make equity investments in two types of entities, RBICs and venture capital funds, for the purpose of providing equity capital to rural business enterprises. Rural entrepreneurs often lack sufficient equity capital to establish and expand businesses that are the mainstay of prosperous rural economies. Venture capital funds provide equity capital in rural business enterprises, which promote economic development and job opportunities in rural communities.

1. Rural Business Investment Companies

Proposed Sec. 615.5176(c)(1) would authorize System institutions to purchase and hold equity investments in RBICs that are established and operate in accordance with 7 U.S.C. 2009cc et seq. As discussed earlier, the Farm Security and Rural Investment Act of 2002 created the Rural Business Investment Program and expressly authorized any Farm Credit System institution to establish and invest in RBICs. Congress intended to promote economic development, create wealth, and expand job opportunities in rural areas through RBIC equity investments. The System's statutory authority to establish and invest in RBICs is incorporated into proposed Sec. 615.5176(c)(1). The proposed rule would enable System institutions to invest in RBICs to the fullest extent allowed by 7 U.S.C. 2009cc et seq. The FCA emphasizes that proposed Sec. 615.5176(c)(1) would authorize System institutions to invest in both leveraged and nonleveraged RBICs.

2. Venture Capital Funds

Proposed Sec. 615.5176(c)(2) would authorize System institutions to invest in venture capital funds which, in turn, invest in rural businesses that provide job opportunities. Under this provision, System institutions would be able to indirectly provide rural entrepreneurs needed equity capital through venture capital funds, such as regional investor networks, which have investment objectives similar to RBICs.

The Center for the Study of Rural America of the Federal Reserve Bank of Kansas identified a significant need for equity capital for rural entrepreneurs because entrepreneurial activity is strongly linked to economic growth.\19\ For this reason, experts conclude that additional focus on rural entrepreneurship can be an effective strategy in combating the decline of traditional resourcebased businesses in [[Page 33937]]
rural areas.\20\ However, rural economies have difficulty attracting venture capital because metropolitan areas usually offer better profits. Policy officials and experts agree that entrepreneurship in remote and sparsely populated rural areas can be challenging because access to skilled labor, technology, and capital is more limited. Investments in venture capital funds that focus on rural entrepreneurs can effectively begin to overcome these barriers to rural businesses. \19\ Mark Drabenstott, et al., ``Main Streets of Tomorrow: Growing and Financing Rural EntrepreneursA Conference Summary,'' Economic Review, Third Quarter 2003, Federal Reserve Bank of Kansas City, pp. 73 and 74.

\20\ Ibid.

Proposed Sec. 615.5176(c)(2) would place specific restrictions on System investment in venture capital funds to ensure that these investments remain small and passive. Additionally, these controls would minimize potential financial risk to the System institutions, while providing the System with flexibility to invest in rural development under the Act.

Proposed Sec. 615.5176(c)(2)(i) would control financial risk by prohibiting any System institution from investing more than 5 percent of its total surplus in venture capital funds and more than 2 percent of its total surplus in any one venture capital fund. The FCA emphasizes that this limit on venture capital funds in proposed Sec. 615.5176(c)(2)(i) is in addition to the overall limit in proposed Sec. 615.5176(e)(i), which prevents total rural community investments at any FCS institution from exceeding 150 percent of its total surplus.

The restrictions in proposed Sec. 615.5176(c)(2)(ii) and (iii) would prevent System institutions from controlling and managing venture capital funds. Proposed Sec. 615.5176(c)(2)(ii) would prohibit any FCS institution from holding more than 20 percent of the voting equity of any venture capital fund. The purpose of this provision is to allow System institutions to invest in venture capital funds that focus on rural areas, while imposing a reasonable limit that prevents any System institution from gaining a controlling interest in any fund. Proposed Sec. 615.5176(c)(2)(iii) would prohibit any FCS institution from participating in the routine management or operation of a venture capital fund.

Finally, proposed Sec. 615.5176(c)(2)(iv) and (v) would establish controls to avoid potential conflicts of interest. Proposed Sec. 615.5176(c)(2)(iv) would prohibit any director, officer, or employee of a System institution from serving as a director, officer, employee, principal shareholder, or trustee of any venture capital fund or of any entity funded by, or affiliated with, the venture capital fund. Proposed Sec. 615.5176(c)(2)(v) would prohibit any System institution from participating in any decision or action of a venture capital fund involving or affecting any customer of the institution. Although proposed Sec. 615.5176(c)(2)(v) would permit a System institution to invest in venture capital funds that hold equity in one of its borrowers, the institution could not participate in decisions or actions that affect such customers. Additionally, the proposed rule does not prohibit System institution directors, officers, or employees from serving in an investment screening or other advisory capacity to a venture capital fund, subject to the restrictions discussed above. System institution representatives serving in an advisory capacity to a venture capital fund also remain subject to FCA conflict of interest regulations and institution policies.
D. Other Investments Approved by the Farm Credit Administration

The FCA's experience with the pilot programs reveals that the types of System investments may change as the needs of rural communities evolve. For this reason, the FCA believes that the new regulation should contain a mechanism for approving investments that currently do not exist, but may emerge in the future. Currently, Sec. 615.5140(e) provides the FCA with the authority to approve new investments that are not specifically authorized by regulation.

Proposed Sec. 615.5176(d) establishes specific criteria for System institutions to apply to the FCA for permission to hold investments that are not expressly authorized by this regulation. Under this proposal, written requests by System institutions would: (1) Describe the proposed project or program in detail; (2) explain its risk characteristics; and (3) demonstrate how such investments are consistent with the System's statutory mandate to serve agriculture and rural communities. In approving such requests, the FCA may impose additional or more stringent conditions than the requirements of this regulation to ensure safety and soundness or compliance with law. E. Restrictions on Rural Community Investments

Other requirements governing System investments in rural communities are covered by proposed Sec. 615.5176(e). These requirements either pertain to safety and soundness or implement statutory requirements.

1. Portfolio Limit

Proposed Sec. 615.5176(e)(1) would authorize each System bank, association, or service corporation to make rural community investments in an amount not to exceed 150 percent of the institution's total surplus. The proposed portfolio limit on rural community investments ensures that lending to farmers, ranchers, aquatic producers, cooperatives, and other borrowers that own the FCS remains the primary activity of System institutions. At the same time, the proposed limit provides the FCS with the flexibility to make investments in an amount that offers meaningful assistance to rural communities and their residents. This limit on rural community investments is compatible with limits that the Act and other FCA regulations impose on System activities that are related to the System's mission.

Based on financial information reported as of December 31, 2007, the proposed limit would authorize the System to invest up to a total of $35.8 billion in rural community investments.\21\ For example, this would permit an FCS association with $1.0 billion in assets and $150.0 million in total surplus to invest up to $225.0 million in rural communities.
\21\ This amount is comparable to the regulatory limits established for the System's rural home lending and investments in farmers' notes activities, which are limited to amounts totaling $35.9 billion for each program as of yearend, although actual amounts outstanding under these programs represented 1.3 percent and less than 1 percent of total outstanding loans, respectively.

The FCA considered the following factors when it decided to propose 150 percent of total surplus as the portfolio limit: (1) The safety and soundness of FCS institutions; (2) the significant needs of rural communities; (3) the FCS's ability and capacity to assist rural communities, and (4) the ability of FCS institutions to fulfill mission objectives. Total surplus provides a basis for each institution's risk tolerance level, and the FCA has historically used this standard to limit System investments in unrated obligations that are less liquid. System institutions also use limits based on similar capital measures to ensure that asset and portfolio concentrations are safely and soundly managed.

This proposed limit also is based on the limits established for the pilot programs. The FCA established individual institution limits equal to 100 percent of total surplus (or in some cases 10 percent of total loans) for investments held under specific pilot programs, and 150 percent of total surplus for an institution's portfolio of all rural community investments. The
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pilot programs evidence that System institutions exercised caution when making investments in rural communities. Institutions have not approached the portfolio limit. Although the proposed rule establishes an upper regulatory portfolio limit, the FCA expects that each System institution would determine an appropriate internal portfolio limit based on the individual institution's objectives, capital position, risk tolerance, and other factors that it considers appropriate, in accordance with Sec. 615.5133(c).

The FCA also considered the System's need to establish a program of sufficient size that could adequately deliver benefits to rural communities while balancing operational efficiency needs. In establishing the portfolio limit, the FCA sought to ensure that each System institution, large or small, could effectively partner with government agencies and nonSystem financial institutions in projects that may positively affect their local rural communities.

The current credit crisis emphasizes the importance of funding for rural development projects and enhancing the liquidity of rural credit markets. The portfolio limit curtails the maximum risk exposure of System institutions, and it also encourages partnerships with non System financial institutions and government agencies that are active in rural development. Collaboration between System institutions and larger, more established financial investors is a way to help rural communities access financing for vital projects, especially during times of economic uncertainty.

2. Obligor Limit

Proposed Sec. 615.5176(e)(2) would establish an obligor limit for investments in rural communities. This provision would not allow any System institution to invest more than 15 percent of its total surplus in investments issued by a single entity, issuer, or obligor. However, the obligor limit would not apply to obligations issued or guaranteed on the full faith and credit of the United States, its agencies, instrumentalities, or corporations. In the event only a portion of the obligation is guaranteed, the nonguaranteed portion of the obligation would remain subject to the obligor limit.

This obligor limit is designed to control undue credit risk from a single counterparty on the capital of any System institution and provide sufficient diversification of an institution's rural community investment portfolio. For safety and soundness reasons, the FCA decided that the obligor limit for rural community investments should be lower than the 20 percent of total capital obligor limit established for investments held by System institutions to maintain liquidity and manage market risks in Sec. 615.5140(d). In contrast to the liquid and marketable securities held under Sec. 615.5140, rural community investments are often unrated and, therefore, capital markets would consider them less liquid. The FCA anticipates that most rural community investments would be held to maturity and would not trade. For these reasons, the FCA proposes an obligor limit for rural community investments that does not exceed 15 percent of the total surplus of each System institution.

This regulatory provision would also require a System institution to count securities that it holds through an investment company towards this 15percent obligor limit to prevent undue risk concentrations. This provision provides an exception when the investment company's holding of the security of any one issuer does not exceed 5 percent of the investment company's total portfolio. The FCA patterned this provision after Sec. 615.5140(d)(2), which applies to investments that FCS institutions hold through investment companies for the purposes of maintaining liquidity or managing market risks.

The FCA emphasizes that proposed Sec. 615.5176(e)(2) establishes a maximum obligor limit for rural community investments. The FCA expects every Farm Credit institution to establish internal obligor limits based on its financial condition and the size and complexity of securities that it contemplates buying and holding. The obligor limit that each System institution sets should be based on both identified risks and its own riskbearing capacity.

3. Maturities for Debt Securities in Rural Communities

Proposed Sec. 615.5176(e)(3) would require most rural community investments to mature in no more than 20 years. However, debt securities may mature in not more than 40 years if the United States or its agencies provide a guarantee or a conditional commitment of guarantee for 50 percent or more of the total issuance or obligation. Proposed Sec. 615.5176(e)(3) establishes terms to maturity that are flexible enough to accommodate typical rural development projects that this rule would authorize. This regulatory approach would enable System institutions to participate in USDA and other State rural development programs that provide a supplemental or partial guarantee, which contributes to, or enhances, wholeproject financing. Also, investments that fund essential rural community facilities, such as hospitals, police and fire stations, and other emergency service facilities, typically require project financing over longer terms to maturity. 4. Exclusion From the Liquidity Reserve

Proposed Sec. 615.5176(e)(4) would require System banks to exclude rural community investments from their liquidity reserve under Sec. 615.5134 of this part. System banks may purchase and hold the eligible investments listed in Sec. 615.5140 to maintain liquidity reserves, manage interest rate risk, and invest surplus shortterm funds in accordance with Sec. 615.5132. Only investments that can be promptly converted into cash without significant loss are suitable for achieving these objectives. Rural community investments are not suitable for liquidity purposes or market risk management because these investments do not typically carry ratings assigned by a Nationally Recognized Statistical Rating Organization and are not actively traded in the established secondary markets.

5. Association Investments

Proposed Sec. 615.5176(e)(5) would implement sections 2.2(10) and 2.12(18) \22\ of the Act, which require each funding bank to supervise and approve the investment activities of its affiliated associations. System banks may discharge their statutory and regulatory
responsibility to approve and supervise an association's rural community investments through covenants in the general financing agreement, policies, or other appropriate formats. System banks may also provide advisory, analytical, and research services that help their affiliated associations to devise strategies for investing in rural communities and managing these assets.
\22\ 12 U.S.C. 2073 (10) and 2093 (18).

6. Attribution of Service Corporation Investments

Proposed Sec. 615.5176(e)(6) would require System service corporations to attribute all rural community investments to their System institution parents based on the ownership percentage of each bank or association. This provision would prevent FCS institutions from utilizing service corporations to exceed the regulatory limits on rural community investments.
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F. Management of Rural Community Investments

Proposed Sec. 615.5176(f) addresses rural community investment management practices at FCS institutions and ensures that System institutions invest in rural communities in a safe and sound manner. If a Farm Credit System institution chooses to invest in rural communities, proposed Sec. 615.5176(f) would require its board of directors to first adopt written policies for managing the institution's investments. These investment management policies must be appropriate for the levels, types, and complexities of each institution's rural community investments. Proposed Sec. 615.5176(f) would also require the board of directors ensure the institution's implementation of procedures and internal controls that ensure compliance with the board's policies and the regulation.

Additionally, proposed Sec. 615.5176(f) would require these written policies to comply with Sec. 615.5133, which governs management practices for investments held for liquidity and risk management. Although rural community investments differ from liquid investments, strong and disciplined investment management practices are essential to the safety and soundness of all investment activities within System institutions. As a result, sound investment management practices prescribed by Sec. 615.5133 are also applicable to rural community investments and, for this reason, the FCA is extending Sec. 615.5133 to rural community investments.

Existing Sec. 615.5133 requires a System institution's investment management policies to address risk tolerance, delegations of authority, internal controls, securities valuation, and reporting to the board. Also, Sec. 615.5133 requires that investment policies be appropriate for the size, type, and risk characteristics of the institution's investments. The FCA expects each System institution to fully and carefully evaluate its risk tolerance in accordance with Sec. 615.5133(c) when it considers purchasing any rural community investments. Finally, proposed Sec. 615.5176(f) expressly exempts those rural community investments that System institutions classify and account for as heldtomaturity under generally accepted accounting principles from the securities valuation requirement in Sec. 615.5133(f). This exemption is based on the different accounting classifications for these securities.

G. Regulatory Flexibility Act

Pursuant to section 605(b) of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.), the FCA hereby certifies that the proposed rule will not have a significant economic impact on a substantial number of small entities. Each of the banks in the System, considered together with its affiliated associations, has assets and annual income in excess of the amounts that qualify them as small entities. Therefore, System institutions are not ``small entities'' as defined in the Regulatory Flexibility Act.

List of Subjects in 12 CFR Part 615

Accounting, Agriculture, Banks, banking, Government securities, Investments, Rural areas.

For the reasons stated in the preamble, part 615 of chapter VI, title 12 of the Code of Federal Regulations is proposed to be amended as follows:
PART 615FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS, AND FUNDING OPERATIONS

1. The authority citation for part 615 is revised to read as follows:

Authority: Secs. 1.1, 1.5, 1.7, 1.10, 1.11, 1.12, 2.2, 2.3, 2.4, 2.5, 2.12, 3.1, 3.7, 3.11, 3.25, 4.3, 4.3A, 4.9, 4.14B, 4.25, 5.9, 5.17, 6.20, 6.26, 8.0, 8.3, 8.4, 8.6, 8.7, 8.8, 8.10, 8.12 of the Farm Credit Act (12 U.S.C. 2001, 2013, 2015, 2018, 2019, 2020, 2073, 2074, 2075, 2076, 2093, 2122, 2128, 2132, 2146, 2154, 2154a, 2160, 2202b, 2211, 2243, 2252, 2278b, 2278b6, 2279aa, 2279aa3, 2279aa4, 2279aa6, 2279aa7, 2279aa8, 2279aa10, 2279aa12); 7 U.S.C 2009cc et. seq.; sec. 301(a) of Pub. L. 100233, 101 Stat. 1568, 1608. Subpart FProperty, Transfers of Capital and Other Investments

2. A new Sec. 615.5176 is added to subpart F to read as follows: Sec. 615.5176 Rural community investments.
(a) Rural communities. As authorized by this section, each Farm Credit System (System) bank, association, or service corporation (hereafter ``institution'') may make rural community investments. All investments that any System institution makes under this section in rural communities must be outside an urbanized area as determined by the latest decennial census of the United States.
(b) Debt securities. Each institution may make investments in rural communities by purchasing and holding debt securities. For the purposes of this section, debt securities are obligations that are commonly recognized in the established capital markets as a medium for investment. Debt securities exclude commercial loans and any instrument or transaction that is more similar to a commercial loan than to a traditional investment instrument or transaction. Debt securities include government obligations, corporate debt obligations, revenue bonds, assetbacked securities, as defined by Sec. 615.5131(a), and mortgage securities, as defined by Sec. 615.5131(h). Debt securities that institutions purchase and hold under this section must provide funding in rural communities for:
(1) Essential community facilities such as hospitals, clinics, emergency services, and schools;
(2) Basic transportation infrastructure, such as roads, bridges, and other public transportation systems;
(3) Revitalization projects that rebuild rural areas recovering from disasters where an emergency has been declared pursuant to law; (4) Rural development projects for which the issuer, sponsor, or provider of a guarantee is:
(i) The United States or any of its agencies, instrumentalities, or corporations, under programs that have the specific purpose of directly financing economic development in rural areas; or
(ii) Any State, the Commonwealth of Puerto Rico, local or municipal governments, or other political subdivisions.
(5) NonSystem financial institutions for their activities that support rural development.
(c) Equity investments. System institutions may also make investments in:
(1) Rural Business Investment Companies that are established and operate in accordance with 7 U.S.C. 2009cc et seq.; or
(2) Venture capital funds that are established to promote economic development and job opportunities in businesses located in rural communities, so long as an institution does not:
(i) Invest more than 5 percent of its total surplus in venture capital funds and more than 2 percent of its total surplus in any one venture capital fund;
(ii) Hold more than 20 percent of the voting equity of any one venture capital fund;
(iii) Participate in the routine management or operation of any venture capital fund;
(iv) Allow any institution director, officer, or employee to serve as director, officer, employee, principal shareholder, or trustee of any venture
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capital fund, or of any entity funded by, or affiliated with any venture capital fund; or
(v) Participate in any decision or action of any venture capital fund involving or affecting any customer of the institution. (d) Other investments approved by the Farm Credit Administration. System institutions may make other investments in rural communities that are not expressly authorized by this section if they are approved by the Farm Credit Administration. Written requests for Farm Credit Administration approval must describe the proposed project or program in detail, explain its risk characteristics, and demonstrate how such investments are consistent with the statutory mandate of the Farm Credit System.
(e) Restrictions on rural community investments(1) Portfolio limit. An institution must not invest more than 150 percent of its total surplus in rural community investments.
(2) Obligor limit. An institution must not invest more than 15 percent of its total surplus in rural community investments issued by any single entity, issuer, or obligor. This obligor limit does not apply to obligations of the United States or its agencies, instrumentalities, or corporations. An institution must count securities that it holds through an investment company towards the obligor limit of this section unless the investment company's holding of the securities of any one issuer does not exceed 5 percent of the investment company's total portfolio.
(3) Maturities for debt securities. Debt securities purchased by institutions under this section must mature in not more than 20 years, except that debt securities may mature in not more than 40 years if the United States or its agencies provide a guarantee or a conditional commitment of guarantee for 50 percent or more of the total issuance or obligation.
(4) Exclusion from the liquidity reserve. No Farm Credit bank shall include any investment made in accordance with this section in its liquidity reserve under Sec. 615.5134 of this part.
(5) Association investments. A System association may hold rural community investments only with the approval of its funding bank. Each district Farm Credit bank must annually review all rural community investments held by its affiliated associations.
(6) Attribution of service corporation investments. All investments in rural communities that service corporations hold under this section must be attributed to their System institution parents based on the ownership percentage of each bank or association.
(f) Management of rural community investments. Before a System institution invests in rural communities, its board of directors must first adopt written policies for managing the institution's rural community investments. Investment management policies must be appropriate for the levels, types, and complexities of each institution's rural community investments. These written policies must comply with requirements of Sec. 615.5133. Investments made under this section that System institutions classify and account for as heldto maturity securities in accordance with generally accepted accounting principles are exempt from the requirements of paragraph (f) of Sec. 615.5133. The board of directors must ensure that the institution implements procedures and internal controls to ensure compliance with the board's policies and the regulation.

Dated: June 10, 2008.
Roland Smith,
Secretary, Farm Credit Administration Board.
[FR Doc. E813382 Filed 61308; 8:45 am]
BILLING CODE 670501P

FOR FURTHER INFORMATION CONTACT Laurie Rea, Associate Director, Office of Regulatory Policy, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA, (703) 883 4414, TTY (703) 8834434; or
Dawn Johnson, Policy Analyst, Office of Regulatory Policy, Farm Credit Administration, Denver, CO, (303) 6969737, TTY (303) 6969259; or Richard A. Katz, Senior Counsel, Office of General Counsel, Farm Credit Administration, McLean, VA 221025090, (703) 8834020, TTY (703) 883 4020.