Organization; Standards of Conduct and Referral of Known or Suspected Criminal Violations; Loan Policies and Operations; Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; General Provisions; Definitions; Disclosure to Shareholders; Disclosure to Investors in System-Wide and Consolidated Bank Debt Obligations of the Farm Credit System, 5740-5768 [06-829]

Agencies

• Farm Credit Administration

[Federal Register Volume 71, Number 22 (Thursday, February 2, 2006)]
[Rules and Regulations]
[Pages 5740-5768]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-829]



[[Page 5739]]

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Part II





Farm Credit Administration





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12 CFR Part 611, et al.



Amendments to Regulations Governing the Farm Credit System; Final Rule

Federal Register / Vol. 71, No. 22 / Thursday, February 2, 2006 / 
Rules and Regulations

[[Page 5740]]


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FARM CREDIT ADMINISTRATION

12 CFR Parts 611, 612, 614, 615, 618, 619, 620, and 630

RIN 3052-AC19


Organization; Standards of Conduct and Referral of Known or 
Suspected Criminal Violations; Loan Policies and Operations; Funding 
and Fiscal Affairs, Loan Policies and Operations, and Funding 
Operations; General Provisions; Definitions; Disclosure to 
Shareholders; Disclosure to Investors in System-Wide and Consolidated 
Bank Debt Obligations of the Farm Credit System

AGENCY: Farm Credit Administration.

ACTION: Final rule.

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SUMMARY: The Farm Credit Administration (FCA, we, or our) issues this 
final rule amending our regulations affecting the governance of the 
Farm Credit System (System). The final rule enhances impartiality and 
disclosure in the election of directors; requires that Farm Credit 
banks and associations establish policies identifying desirable 
director qualifications; requires boards to have a director or an 
advisor who is a financial expert; requires System institutions to 
establish director training procedures; and ensures that boards conduct 
annual self-evaluations. The final rule addresses the term of service 
and removal of outside directors, while requiring all Farm Credit banks 
and associations with assets over $500 million to have at least two 
outside directors. The rule also provides associations with small 
boards an exemption from having at least two outside directors. The 
rule further requires that Farm Credit banks and associations have 
nominating committees and that all System institutions have audit and 
compensation committees. The final rule clarifies the current rule on 
disclosure of conflicts of interest and compensation. The final rule 
does not apply to the Federal Agricultural Mortgage Corporation (FAMC).

DATES: Effective Date: This regulation will be effective 30 days after 
publication in the Federal Register during which either or both Houses 
of Congress are in session except for Sec. Sec.  611.210(a)(2), 
611.220(a)(2)(i) and (ii), 611.325, and 620.21(d)(2) which will be 
effective one year from the effective date of this rule. We will 
publish a notice of the effective date in the Federal Register.
    Compliance Date: Compliance with board composition requirements 
(Sec. Sec.  611.210(a)(2) and 611.220(a)(2)(i) and (ii)) and 
establishment of bank nominating committees (Sec. Sec.  611.325 and 
620.21(d)(2)) must be achieved 1 year from the effective date of this 
rule. All other provisions require compliance on the effective date of 
this rule.

FOR FURTHER INFORMATION CONTACT:


Gary Van Meter, Deputy Director, Office of Regulatory Policy, Farm 
Credit Administration, McLean, VA 22102-5090, (703) 883-4232, TTY (703) 
883-4434,
 Or
Laura D. McFarland, Senior Attorney, Office of General Counsel, Farm 
Credit Administration, McLean, VA 22102-5090, (703) 883-4020, TTY (703) 
883-4020.

SUPPLEMENTARY INFORMATION:

I. Objectives

    The objectives of this rule are to:
     Protect the safety and soundness of System institutions by 
strengthening the independence of System institution boards and 
incorporating best governance practices; and
     Support borrower participation in the management, control 
and ownership of their respective System institutions.

II. Background

    The Farm Credit Act of 1971, as amended (Act),\1\ authorizes FCA to 
issue regulations implementing the provisions of the Act. FCA 
regulations ensure the safe and sound operations of System institutions 
and establish minimum disclosure levels of financial information to 
stockholders, investors, and potential investors in the System.\2\ 
Congress explained in section 514 of the Farm Credit Banks and 
Associations Safety and Soundness Act of 1992 (1992 Act) that 
disclosure of financial information and the reporting of potential 
conflicts of interest by System directors, officers, and employees 
helps ensure the financial viability of the System.\3\
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    \1\ Pub. L. 92-181, 85 Stat. 583.
    \2\ Section 5.17(a)(8) to (10) of the Act (12 U.S.C. 2001, et 
seq.).
    \3\ Pub. L. 102-552, 106 Stat. 4131.
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    The System has continued to grow in complexity, with an increasing 
demand for System institutions to maintain qualified boards and provide 
transparency in reporting to stockholders and investors. Also, market 
expectations for investments, including System-wide debt obligations, 
have changed in response to passage of the Sarbanes-Oxley Act of 
2002.\4\ Congress enacted Sarbanes-Oxley after revelation of accounting 
and financial management scandals involving public companies, to 
strengthened financial disclosure, reporting, and accountability 
requirements for publicly traded companies and other entities 
registered with the Securities and Exchange Commission (SEC).
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    \4\ Pub. L. 107-204, July 30, 2002.
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    While Farm Credit banks and associations are not subject to the 
governance requirements of Sarbanes-Oxley, the FCA Board determined in 
September 2003 that our regulatory governance provisions needed 
updating to reflect the changing environment in which the System 
operates.\5\ On January 19, 2005, we published a proposed rule (70 FR 
2963) to amend those parts of our regulations affecting governance of 
System institutions. The proposed rule addressed five governance areas: 
(1) Director training, qualifications, and self-evaluations, (2) board 
composition, (3) nominating committees, (4) conflicts of interest, and 
(5) audit and compensation committees. We extended the comment period 
for the proposed rule from March 21, 2005 to May 20, 2005 at the 
request of several System institutions and the Farm Credit Council 
(FCC), acting for its membership.\6\
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    \5\ FCA Fall 2003 Unified Agenda, 68 FR 53168 (September 9, 
2003).
    \6\ 70 FR 9016, February 24, 2005.
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III. Comments and Our Response

    We received 348 comment letters on our proposed rule, all but two 
from individuals and entities associated with the System. Of the 
comments received, 342 letters were from officers and directors of 85 
System associations, each of the five Farm Credit banks, the Federal 
Farm Credit Banks Funding Corporation (Funding Corporation), and the 
FCC (System commenters). One borrower of the System and one member of 
the general public also provided comments on the rule. The majority of 
the System commenters supported the FCC comments, adding individual 
elaborations where they deemed appropriate. We also received five 
comments as part of our regulatory burden initiative addressing areas 
covered in the proposed rule and address them in this rule. We discuss 
the comments to our proposed rule and our responses below. Some 
commenters also responded to our request for comments on the existing 
rule for waiving the statutory compensation limit of Farm Credit bank 
directors, which we discuss separately below. Those areas of the 
proposed rule that did not receive comments are finalized as proposed.

[[Page 5741]]

IV. General Issues

    We received many comments on issues not directed to a single 
specific rule section. These comments are addressed here using the 
following nine categories: Our authority to regulate matters contained 
in System bylaws; the Regulatory Flexibility Act; our policy statement 
on rulemaking; nonregulatory approaches to governance; the extent of 
our examination and enforcement authorities; cooperative principles; 
independent directors; other general comments; and cost analysis.

A. System Institution Bylaws

    A significant number of System commenters stated the proposed rule 
addressed issues reserved to System institutions through their bylaws 
and that we lack authority to regulate these issues. The commenters 
cited section 5.17(b) of the Act as precluding FCA's involvement in any 
area covered by institution bylaws. Some commenters acknowledged our 
previous assertion that the prohibition on bylaw approval doesn't 
preclude rulemaking on matters affecting an institution's bylaws, 
stating that our position applies to the operational conduct of System 
institutions, not board issues. The commenters explain that regulations 
in areas addressing boards of directors would directly supersede a 
subject Congress expressly left to an institution's bylaws, making 
section 5.17(b) meaningless. Commenters also suggested that any rule on 
governance is functionally equivalent to our approval of bylaws.
    The Act at section 5.17(b) states that we may not approve bylaws, 
either directly or indirectly. Congress added the prohibition on bylaw 
approval in 1987 as a technical change.\7\ As explained by Congress, 
this technical change removed the ``last vestiges of the former 
management role of the Farm Credit Administration.'' \8\ This statement 
was in reference to the then statutory requirement that System 
institutions send bylaws to our offices for review and approval. This 
practice stopped when section 5.17(b) was enacted.
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    \7\ Section 110 of the Agricultural Credit Act of 1987, Pub. L. 
100-233.
    \8\ H. AMDT 425 on HR 3030 (August 4, 1987). In the Farm Credit 
Amendments Act of 1985 (Pub. L. 99-205), Congress amended the Act to 
make us an arm's-length regulator, while increasing our regulatory 
powers.
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    We recognize that section 5.17(b) removed our role in issuing prior 
approvals of bylaws. However, nothing in the language of 5.17(b) or its 
legislative history discusses our regulatory authority. Had Congress 
intended to limit our regulatory authority on any issue that may also 
be addressed in a System institution's bylaws, the addition of section 
5.17(b) would not have been characterized as a technical change and 
Congress would have also removed or amended section 5.17(a)(9) of the 
Act. Section 5.17(a)(9) directs us to issue rules and regulations 
``necessary or appropriate'' to carry out the Act. Congress left this 
authority, and others, in place when prohibiting bylaw approval. Thus, 
Congress did not remove or limit our authority to issue regulations 
governing any matter affecting institution bylaws by adding section 
5.17(b).
    In pursuit of ensuring a safe and sound System and carrying out the 
Act, institution bylaws are necessarily impacted by our rules. Issuing 
rules impacting bylaws does not mean we are approving bylaws in 
violation of section 5.17(b) of the Act. If we took the comments to the 
fullest extent, a System institution could supersede any regulation 
simply by adding a contrary bylaw provision. This is clearly not what 
Congress intended when adding section 5.17(b) to the Act. Section 
5.17(b) went to a particular past practice and was not intended to 
exclude us from regulating all matters that may also be addressed by 
System bylaws. Additionally, while the authority of System institutions 
to establish bylaws is fairly broad, it is not without limits. Bylaws 
must be consistent with applicable laws and regulations and we retain 
the responsibility to examine institution bylaws to ensure compliance. 
Consequently, we may regulate the terms and conditions by which 
institutions exercise their powers through their bylaws, while not 
approving the bylaws themselves, and then examine compliance with our 
regulations.

B. Regulatory Flexibility Act Analysis

    Commenters questioned our Regulatory Flexibility Act (RFA) \9\ 
certification. In the proposed rule, we certified the rule will not 
have a significant economic impact on a large number of small entities. 
Our certification considered each Farm Credit bank together with ``its 
affiliated associations.'' The commenters objected to our combining 
associations with Farm Credit banks, stating that because each 
institution has to comply with the regulatory requirements each should 
be considered individually for purposes of identifying economic impact. 
Commenters from one association specifically objected to the 
implication that no ``small entity'' would be burdened by the rule.
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    \9\ 5 U.S.C. 601 et seq.
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    Under the RFA, an agency must certify that a rulemaking will not 
have a significant economic impact on a substantial number of small 
entities. If the rulemaking will have such an impact, then the agency 
must conduct a regulatory flexibility analysis. The RFA definition of a 
small entity incorporates the Small Business Administration (SBA) 
definition of a ``small business concern,'' including its size 
standards. A small business concern is one independently owned and 
operated, and not dominant in its field of operation. The SBA explains 
that ``independently owned and operated'' is determined, in part, by 
the entity's affiliation with other businesses. Generally, an affiliate 
is one that is controlled by, or has control over, the entity. 
Businesses with ownership, management, and contractual relationships 
that make them economically dependent may also be affiliates. For 
purposes of the RFA, the interrelated ownership, control, and 
contractual relationship between associations and their funding banks 
are sufficient to permit them to be treated as a single entity.
    Further, System institutions fall under the SBA ``Credit 
Intermediation and Related Activities'' size category for small 
business concerns and the ``All Other Non-Depository Credit 
Intermediation'' subcategory. This subcategory defines a small entity 
as one with average annual assets less than $6 million. As affiliates, 
the combined average annual assets of each Farm Credit bank and its 
affiliated associations exceed $6 million. Therefore, System 
institutions do not satisfy the RFA definition of ``small entities.''

C. Compliance With FCA Policy Statement 59 ``Regulatory Philosophy''

    The FCC board of directors sent a separate letter from the FCC 
letter commenting on the entire rule, stating that the proposed 
governance rule was inconsistent with FCA Board Policy Statement 59 
(FCA-PS-59 (1994)).\10\ Two other commenters also stated that we 
violated FCA-PS-59 (1994). This policy statement sets out our 
philosophy on issuing regulations necessary to carry out the Act and 
promote the safety and soundness of the System. The FCA Board, 
independent of the comment letters received on the proposed governance 
rule, issued a

[[Page 5742]]

revised FCA-PS-59 (1994) on June 8, 2005.
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    \10\ Statement on Regulatory Philosphy, 59 FR 32189 (June 22, 
1994). Updated May 16, 1995, 60 FR 26034.
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    The FCC board asserted the proposed rule violates the guidelines 
contained in FCA-PS-59 (1994) in five areas. First, they claimed they 
found no reasoned determination on the beneficial value of the proposed 
rule relative to the cost, stating the rule will impose greater costs 
on System institutions. A separate commenter also stated we had not 
completed a cost-benefit analysis before proposing the rule. While we 
did consider the proposed rule's cost to System institutions, the 
proposed rule did not explain clearly our cost-benefit consideration. 
We have included our cost-benefit review at section IV.I. of this 
preamble.
    Second, the FCC board remarked that we did not specifically 
identify risks or problems needing to be addressed in a rule. The 
provisions in FCA-PS-59 (1994) are not intended to limit us to issuing 
regulations only when there is an existing problem. The proposed rule 
explained that recent corporate scandals led us to reevaluate the 
preventive safeguards in our regulations. No existing problem of the 
nature leading to passage of Sarbanes-Oxley presently exists in the 
System, but our responsibility as a safety and soundness regulator 
requires us to be proactive, as well as reactive.
    Third, the FCC board stated the proposed rule contained ``explicit 
operational direction'' instead of performance criteria as stated in 
FCA-PS-59 (1994). FCA-PS-59 (1994) states that we will, to the extent 
feasible, specify performance criteria and objectives, but does not 
preclude the use of operational constraints. FCA-PS-59 (1994) states 
that any operational constraints we regulate will be based on specific 
statutory requirements or achieving regulatory objectives. The rule 
provides performance criteria in many areas, most notably in director 
qualifications, training, and elections. Some operational direction was 
provided for board committees and for director removal to ensure these 
actions occurred in a manner considered suitable for safety and 
soundness or to protect the cooperative structure of the System. To 
address commenter concerns, we have more clearly explained our reason 
for each provision of this final rule in the section-by-section portion 
of this preamble.
    Fourth, the FCC board challenged the statutory basis for the 
proposed rule because they did not find specific statutory provisions 
for most of the rule. We issued our proposed rule under our general 
authority at section 5.17(a)(9) and (10) of the Act, which empowers us 
to issue regulations for the safety and soundness of the System and to 
carry out provisions of the Act. Further, section 5.17(a)(8) authorizes 
us to regulate the preparation and distribution of information on the 
financial condition of System institutions to stockholders and 
investors. Many of the provisions in the rule relate to the financial 
condition of System institutions, such as the Annual Meeting 
Information Statement (AMIS), disclosure of conflicts of interest, and 
the role of audit committees in preparing financial reports.
    Fifth, the FCC board claimed we did not consider the approach taken 
by other financial regulators, stating we inconsistently followed their 
approach and that we were applying Sarbanes-Oxley to the System, a law 
they state ``Congress specifically chose not to apply to the System.'' 
They also stated that events in the community of publicly traded 
companies are ``tenuous justification'' for updating our regulations. 
We stated in the preamble to the proposed rule that Farm Credit banks 
and associations are not subject to the governance provisions of 
Sarbanes-Oxley. We do not agree that our proposed rule is inconsistent 
with what other regulators require. We used Sarbanes-Oxley as a guide, 
along with the governance rules of the SEC, the Federal Housing Finance 
Board (FHFB) and other regulators, as well as the System's own 
governance efforts. The FCA, as an independent regulator of the System, 
is not required to follow the actions of other regulators. Instead, 
FCA-PS-59 (1994) states that we will consider the policy positions of 
other regulators to decide if we should follow them or take a different 
approach, which we did in the proposed governance rule.
    Finally, the FCC board's letter discussed our use of the disclosure 
and conflict of interest provisions in section 514 of the Safety and 
Soundness Act of 1992. They stated that governance is unrelated to 
disclosures and conflicts of interest. They also commented that our 
last review of regulations implementing the 1992 Act, conducted more 
than 10 years ago, is sufficient absent a formal study or ``reliable 
source'' suggesting our regulations are inadequate. Good governance 
involves accountability and transparency, thus disclosing conflicts of 
interest and reporting to stakeholders directly responds to those 
issues. We are charged with examining and regulating the System. As 
part of that responsibility, we periodically review our regulations in 
response to changes within the System, the financial community, or 
agriculture. Proposals to modify rules are based on our careful study, 
research and analysis. A requirement that we hire a consultant to study 
the regulations before we amend them would be inappropriate.

D. Nonregulatory Approach to Governance

    Most of the System commenters supported our objective of improving 
System governance, but questioned the need for regulations. Of these, 
194 commenters asked that we withdraw the rule and work with the System 
to find nonregulatory ways to strengthen institution governance. These 
commenters remarked that System institutions are working to improve 
governance independent of FCA regulatory requirements and should be 
allowed to continue their efforts without having to incorporate 
potentially different governance standards. Some commenters suggested 
the rule should be withdrawn until the System completes its own self-
governance efforts. Others explained that voluntary governance 
policies, incorporating both the spirit and intent of governance, are 
more appropriate for the System rather than prescriptive regulations 
designed to make the System conform to publicly traded companies.
    We are not withdrawing the rule, but have withdrawn or amended 
certain provisions based on specific comments. Our governance rule sets 
a minimum level of performance that is mandatory for all System 
institutions, including those that may not endorse the System's 
voluntary initiatives. While voluntary governance is valuable, it does 
not replace the stability that rules provide in assuring System 
stakeholders of the safety and soundness of the System. We have a 
responsibility to address these issues given the importance of strong 
governance to the safe and sound operations of the System and the 
current business climate in which the System operates. Our intent is to 
ensure that appropriate governance standards exist for all System 
institutions. As we discuss in section IV.F. of this preamble, the 
cooperative structure of the System was a prime consideration in our 
governance rulemaking, and we reviewed the rules for public companies 
for information purposes and identification of the evolving practices 
of the marketplace. We believe the assurances derived from a regulatory 
minimum standard and the System's voluntary governance efforts will 
benefit the System by increased stockholder, investor, and public 
confidence.
    Commenters stated that the rule seeks consistency across the System 
without explanation and does not appropriately

[[Page 5743]]

consider the different management needs of each institution. System 
commenters asked that each institution be allowed to determine how to 
address governance areas based on the institution's size, complexity, 
risks, and resources. Some System commenters questioned if we 
recognized the different operational behaviors of the institutions. 
Another commenter stated that our governance rule tries to centralize a 
decentralized System. This commenter also remarked that the rule may 
inhibit growth due to its rigidity. As an alternative, many commenters 
asked that we rely on our examination and enforcement authorities or 
issue rules that require institutions to establish governance policies 
within identified areas and examine implementation of those policies 
based on individual institution operations.
    While we believe it is important to preserve individual institution 
operating flexibility wherever and whenever possible, our 
responsibility as regulator requires us to issue regulations we 
determine appropriate for safety and soundness reasons. We carefully 
consider the size, complexity, risks, and resources of System 
institutions when developing our rules, and incorporate variations and 
flexibility as appropriate. Regulations necessarily place limits on 
individual institution flexibility to ensure appropriate business 
practices are consistently followed in all operating environments. The 
final rule includes regulatory relief in certain provisions, 
particularly for smaller institutions, where complexity and risks are 
limited. Further, we believe that this rule does not centralize the 
System but facilitates our ongoing examinations of System compliance 
with governance activities.
    The FCC also stated that governance rules are not necessary because 
the System is the only government-sponsored enterprise (GSE) with a 
fully independent safety and soundness regulator having full 
enforcement powers and an entirely self-funded insurance fund under the 
direction of another independent regulator. They further commented that 
there are enough regulations already in place to address governance of 
System institutions. They also cited ``extensive self-regulating'' 
practices in place such as the general financing agreements (GFA), 
market access agreement (MAA), and contractual interbank performance 
agreement (CIPA). Commenters also highlighted the System-wide 
disclosure program managed by the Funding Corporation. One commenter 
claimed the System as a whole implemented the creation of the insurance 
fund, the System-wide disclosures, the GFA, the MAA, and other internal 
controls on a voluntary basis so governance rules are not needed.
    We recognize the System has taken steps to enhance market 
discipline and transparency in its reporting and disclosures, but this 
rule is necessary to provide clear guidelines that will facilitate our 
on-going examinations of, and System compliance with, governance 
activities. The GFAs, MAA, and CIPA mentioned by commenters are 
supported by, and operate within, statutory authorities and regulatory 
constraints. While these System agreements support consistent and sound 
financial conditions, they do not focus directly on the governance 
practices of individual institutions. Additionally, we note that the 
insurance fund was created by Congress as part of the Agricultural 
Credit Act of 1987 \11\ and is available to cover losses when an 
institution fails. Insurance funds are generally not considered 
governance tools. Proper governance helps prevent loss through better 
operations, thereby avoiding the need to use insurance funds and 
enforcement authorities to resolve problems.
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    \11\ Pub. L. 100-233 (January 6, 1988).
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    Commenters remarked that the proposed rule implements no new 
statutory provision and does not respond to a specifically identified 
safety and soundness issue. The FCC also referenced the instructions of 
the Farm Credit System Reform Act of 1996 (1996 Act) \12\ to reduce 
regulatory burdens, stating that any rulemaking after 1996 is held to a 
higher ``burden of proof'' that a need exists for a rule. One commenter 
specifically stated that a rule increasing reporting and disclosures to 
stockholders will not result in a more informed or involved membership. 
Another commenter stated that increasing regulations takes away the 
control of the board and management to effectively run their 
operations. Several commenters expressed concern that we were making 
changes just for the sake of change. Some stated the proposition that 
we should only issue rules when there is a problem, real or perceived. 
They also remarked that the rule might send the message to the 
marketplace that we, as the regulator, consider the System to have a 
governance problem. Another commenter stated we had gone beyond our 
role as a safety and soundness regulator.
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    \12\ Pub. L. 104-105, 110 Stat. 162 (February 10, 1996).
---------------------------------------------------------------------------

    We disagree that this rule is not needed or is a change for the 
sake of change. We believe the rule will result in a better informed 
and more involved membership. Congress charged us to issue regulations 
to ensure the safety and soundness of the System. With the recent 
growth of the System, increased sophistication in financial markets, 
and on-going scrutiny of public and agency financial activities and 
related reporting practices, we are obligated to review current 
practices and regulatory standards to ensure the continuing safety and 
soundness of System institutions both collectively and individually. As 
explained in section IV.C. of this preamble, we have flexibility to 
issue rules in response to a problem or proactively to ensure continued 
safe and sound business operation. Our proactive rulemaking in the area 
of governance should make it clear to the marketplace that we do not 
see a governance problem in the System, but instead are acting to 
update regulatory requirements that preserve the good standing of the 
System. We also disagree that the rule takes over or reduces board 
control. The rule clarifies existing board responsibilities and 
authorities while providing boards with more tools to carry out their 
fiduciary and oversight responsibilities. Finally, this rule complies 
with the 1996 Act. Section 212(b) of the 1996 Act requires us to 
continuously review our regulations to eliminate rules that are 
unnecessary, unduly burdensome, costly, or not based on law. The 1996 
Act specifies that we are to make these eliminations only if they would 
be consistent with law, safety, and soundness. As explained throughout 
this preamble, this rule is consistent with the law, safety, and 
soundness concerns.

E. Examination and Enforcement Authority

    Many System commenters cited our examination and enforcement 
authorities as a reason why regulations are unnecessary. The FCC 
explained that board members must certify receipt of an examination 
report, which is presented to an institution's board, and our examiners 
may then meet in executive session with the board to explain the 
report. Commenters also stated that we have all the enforcement powers 
necessary to correct any unsafe or unsound governance practice without 
this rule. A commenter stated that we may examine for governance, not 
impose operating procedures, and the examination process allows us to 
address specific issues as they arise instead of applying a rule to the 
entire System.

[[Page 5744]]

    We examine to ensure the safety and soundness of System 
institutions and their compliance with laws and regulations. This role 
is not a substitute for our responsibility to issue regulations 
implementing the Act and ensuring the safety and soundness of System 
institutions. Our regulations provide minimum standards of performance 
by System institutions. Our examiners use our rules as the basis for 
compliance determinations and to require any necessary corrective 
actions. Regulations reduce the likelihood that exams will uncover 
unsafe and unsound practices and provide a minimum standard of 
performance to assure stakeholders of the safe and sound operations of 
the System. While we agree with the commenters that we have a high 
level of enforcement authority, we do not view them as our primary tool 
for ensuring the safety and soundness of the System. This is ensured by 
a clear set of rules and thorough regular examinations.

F. Cooperative Structure of the System

    Most System commenters expressed the opinion that we did not give 
enough consideration to the cooperative nature of the System in our 
proposed rule. Some stated that the cooperative ownership of the System 
provides more extensive safeguards than non-cooperative businesses. 
Commenters also stated that we were trying to change the cooperative 
nature of the System. Other commenters stated that we do not understand 
that they, as fellow owners, are also directly affected by institution 
operations and stand to gain or lose by how it is run, unlike public 
companies. One commenter pointed out that System directors do not have 
the same motivations and temptations as corporate directors since 
System stock is not publicly traded and has no market value.
    We drafted our rule with full consideration of the System's 
cooperative structure. In developing both the proposed and final rule, 
we first relied on the requirements of the Act, safety and soundness 
concerns, overriding public policy, and the cooperative structure of 
the System. We agree that a cooperative structure may provide greater 
safeguards than other structures for many of the reasons given by the 
commenters. However, the cooperative structure of the System relies on 
owner control and participation, supported by accurate and timely 
information to owner stockholders, as well as their directors, who act 
in stockholders' behalf. The rule provides flexibility for individual 
System institutions, while establishing standards for governance that 
support cooperative principles and complies with applicable statutory 
requirements.
    Commenters also stated that issuing a regulation to implement best 
practices is unwise. Commenters pointed out that best practices change 
often while regulations change slowly. Another commenter remarked that 
using regulations to implement best practices inhibits System 
institutions from adjusting their governance practices in a timely 
manner. Still another commenter questioned the rationale in adopting 
best practices that may not be in the best interest of System 
stockholders. Others remarked that by issuing a rule on best practices, 
we demonstrate little respect for the ability of each institution's 
board to put best practices into place on its own.
    We believe it is appropriate to use best practices in our rule. We 
used those best practices of System institutions and other corporations 
that we considered appropriate for the long-term safety and soundness 
of the System. We used corporate best practices because System 
institutions are, by requirements of the Act, incorporated and 
considered corporate entities for specific purposes. We do not feel 
this creates a conflict with the cooperative nature of the System, as 
most non-System cooperatives are corporate entities. While we recognize 
that details associated with best practices may change over time, the 
underlying principles have been identified in the rule with sufficient 
flexibility in their application to accommodate most changes in best 
practices.
    One commenter said that our authority as a regulator to establish 
governance practices was transferred to the System in 1987 and we were 
establishing governance practices in conflict with SEC rules. The 
commenter also stated that our rule could hinder progress and we should 
not exceed the governance requirements of other regulators. Another 
commenter stated that our rule went beyond reasonable or appropriate 
regulatory guidance, instead becoming burdensome and interfering. This 
commenter also stated that our rule exceeds non-System regulatory 
schemes, which often only require companies to disclose whether or not 
a particular practice is adopted.
    Our authority to regulate governance matters was not transferred to 
the System in 1987. To the extent that the commenter making this 
statement is referring to our authority to approve bylaws, we address 
that issue in section IV.A. of this preamble. We disagree with the 
commenters that our rule is inconsistent with, or more burdensome than, 
what other regulators require. Although we are not required to follow 
the actions of other regulators, we did consider their governance 
actions. We considered the governance actions of the FHFB and the 
cooperative lending institutions it regulates, because of the 
similarity in structure to the System. We also paid close attention to 
the SEC as the issuer of regulations carrying out Sarbanes-Oxley but 
relied less on the Office of the Comptroller of the Currency (OCC), 
Office of Thrift Supervision (OTS) and Office of Federal Housing 
Enterprise Oversight (OFHEO) individual governance rules because a 
portion of the entities they regulate register with the SEC and 
therefore fall under certain SEC governance rules. Many of the 
provisions in our proposed rule are similar to the rules of other 
regulators, deviating where we determined their rules were not 
consistent with our role as an arm's-length regulator or with the 
cooperative structure of the System.

G. Independent Directors

    Several System commenters stated that our use of the word 
``independent'' in the rule was inappropriate. They explained that 
director independence means that management does not serve on the board 
of directors and most System directors are independent. The FCC further 
stated that the Act, our existing regulations, and institution bylaws 
already mandate independence as defined by the commenters. Other System 
commenters stated we were misrepresenting all System directors, whom 
they stated have ``absolute independence from management.'' One 
commenter stated that the institutions' boards should develop a charter 
defining independence and operate accordingly.
    We do not agree with the commenters' definition of independent when 
discussing System boards. The commenters rely on the corporate 
community's use of the term. We deliberately chose not to use the 
common corporate understanding of ``independent'' for the very reasons 
cited by the commenters. We instead used the term based on our existing 
conflict of interest rules at part 612 and certain sections of the Act. 
Our use of the word ``independent'' for committee memberships precludes 
employment, contractual business relationships, and lending 
relationships that would interfere with a director's ability to 
exercise disinterested and objective judgment. The term as applied to 
the outside director is restricted to the Act and legislative history 
of the Act discussing ``disinterested'' directors and

[[Page 5745]]

is based on a lack of ownership interest in the institution or System, 
thereby offering a different perspective from the owner-directors.

H. Other General Comments

    We received comments on portions of the proposed rule preamble 
language that do not address regulatory provisions and result in no 
change to the rule. Specifically, commenters stated that we proposed a 
requirement for a Code of Ethics without considering existing 
safeguards, that institutions should be allowed to adopt a Code in a 
manner they determine appropriate, and that we should not suggest a 
Code of Ethics for directors and all employees. In the preamble to the 
proposed rule, we encouraged each System institution to adopt a Code of 
Ethics; we made no proposal requiring a Code of Ethics. We explained 
that we were not regulating a Code of Ethics, but encouraging System 
institutions to follow current best practices.
    Several System commenters also criticized us for indicating our 
willingness to participate in System training. The commenters stated 
that such participation was inappropriate for an arm's-length regulator 
and an unwarranted intrusion into System affairs and activities. We are 
now clarifying that our preamble statement reaffirmed our long-standing 
commitment to support System training, which does not compromise our 
role as arm's-length regulator.
    A public commenter stated that we had left out the general public 
as a stakeholder when explaining the purpose of our rule. The commenter 
also suggested more public representation on System boards of 
directors. We disagree; we gave appropriate consideration to the public 
stakeholders when drafting our rule. The System is composed of private 
cooperative entities and, although its GSE status gives it a public 
policy purpose, it does not convert System institutions into 
governmental entities or public companies. As to public representation 
on System boards, the Act provides clear direction on System board 
composition. The cooperative nature of the System requires, at a 
minimum, a System board to be comprised primarily of stockholder-
borrowers, thus preventing a majority public representation as 
requested by the commenter.
    One commenter stated our rule was forcing associations to merge or 
consolidate into larger entities. Another commenter remarked that we 
did not acknowledge the legitimacy of small institutions, placing 
pressure on smaller associations to merge, similar to the pressure they 
receive from their district bank. We are not directly or indirectly 
forcing any institution to merge. The rule provides several small 
institution exemptions to primary governance issues out of concern for 
the economic burden smaller associations might encounter if required to 
follow all aspects of the rule.

I. Cost Analysis

    Several commenters objected to our use of the word ``believe'' in 
the preamble out of concern that our proposal might be based more on 
conjecture than demonstrated need or facts. Commenters also questioned 
our consideration of the implementation cost of the rule. Use of the 
word ``believe'' expresses our conclusion that aspects of the proposed 
rule are needed, are in accordance with our careful study of the 
issues, and are based on our research, analysis, and statutory 
requirements or authorities. As most System commenters noted, while 
they objected to the added regulatory requirements, they supported the 
improved governance standards and, in fact, had already implemented 
many of them. This factored significantly in our consideration of the 
rule's cost to System institutions. We identified three provisions 
having potential cost implications: (1) The addition of a second 
outside director; (2) the implementation of director orientation and 
training programs; and (3) the inclusion of a financial expert on the 
board.
    A second outside director will result in increased salary and 
benefit expenses for those institutions without two outside directors. 
Given its small percentage of overall System expenses, we do not 
believe this cost is significant enough to override the policy benefits 
of additional outside directors. However, we noted the impact to 
smaller associations could exceed our average cost computation and 
amended the rule accordingly. Likewise, director training and 
orientation may result in increased costs if an institution does not 
already have such a program. Based on comments received, most 
institutions already have strong training programs and our rule would 
likely result in changes to the types of courses taken rather than 
increasing the number of courses taken, thereby minimizing costs.
    There may be added costs to locate a financial expert if none are 
currently on an institution's board. We considered the nature of an 
institution, its complexity, risks, and location to provide more 
flexibility and board discretion in how to meet this requirement. In 
doing so, we believe we have minimized the costs for most institutions. 
Since these added requirements and the minimally related costs 
associated with them are designed to enhance the safety and soundness 
of System institutions, we conclude the resulting benefits, including 
improved investor and stockholder confidence, will exceed the added 
costs.

V. Section-by-Section Analysis

A. Definitions

1. Entity [Sec.  612.2130]
    We received 12 letters on the definition of ``entity'' in part 612 
of our regulations. Eight generally objected to the change and four 
commented that they had no objection. One commenter disagreed with 
removing the exception for System institutions, explaining that 
transactions between institutions should not be treated differently 
from other non-System financial institutions under our standards of 
conduct rules. We make no changes to this provision in the final rule, 
but make a clarifying technical change to Sec.  612.2150(d). Without 
this clarification, Sec.  612.2150(d) may have been read to affect 
intra-System transactions.
2. Outside Director [New Sec.  619.9235]
    We received 23 System comment letters on our use of the terms 
``outside'' and ``inside'' to identify director positions. Commenters 
stated that these terms were not found in the Act and suggested we use 
the terms ``Nonaffiliated Board Selected Director'' and ``Affiliated 
Board Selected Director.'' One commenter pointed out that agents may 
serve as outside directors for banks under the Act, but did not 
disagree with the definition excluding agents from serving as outside 
directors for any institution. We final this provision as proposed 
because there were no comments disagreeing with the actual definition 
of ``outside director.'' We also note that Congress uses and defines 
the term ``outside director'' in section 7.12 of the Act, so our use of 
the term is appropriate.
3. Senior Officer [Sec. Sec.  611.1223, 612.2155, 620.1, 620.5, and New 
619.9265]
    We received nine System letters objecting to issuing a specific 
definition of ``senior officer'' instead of allowing each institution's 
board to define the term. Two commenters asked for clarification on the 
meaning of ``major policy-making function,'' explaining that only the 
board makes policy decisions. One commenter asked that we use the SEC 
definition of ``senior officer'' instead of the one proposed.

[[Page 5746]]

Another commenter expressed concern that the definition may end up 
including all officers.
    Our definition of senior officer is similar to, but less inclusive 
than, the SEC definition of ``executive officer.'' \13\ We included 
deviations from the named positions in the SEC definition based on 
System occupations and also limited the use of ``policy making'' to 
major policy making. We clarify that while the rule identifies the 
titles of the senior officers included in this definition, System 
institutions are not required to use these titles. Officers 
accomplishing the functions of these offices while using other titles 
are regarded as senior officers for purposes of our regulations. Each 
institution board retains the ability to designate who is a senior 
officer through their hiring practices and the extent to which they 
include officers, not named in our definition, in major policy making.
---------------------------------------------------------------------------

    \13\ SEC Rule 3b-7 defines an ``executive officer'' as the 
president, any vice president of the registrant in charge of a 
principal business unit, division or function (such as sales, 
administration or finance), any other officer who performs a policy 
making function or any other person who performs similar policy 
making functions for the registrant.
---------------------------------------------------------------------------

B. Bank and Association Boards of Directors

1. Director Qualifications and Training [New Sec.  611.210]
a. Qualifications
    We received 100 System letters on the requirement for boards to 
establish director qualifications. Of the comments received, 48 
objected to being required to establish director qualifications and to 
our identifying specific areas of experience. Other commenters 
expressed concern that establishing qualifications would eliminate many 
people who are able to run a successful business or would fail to 
consider broader qualities that determine a candidate's ability to 
serve. They also stated that establishing director qualifications makes 
it difficult to attract qualified stockholders willing to serve on the 
board. Still other commenters stated that directors lacking established 
qualifications under this provision, especially young, beginning, and 
small (YBS) borrowers, are capable of learning the information they 
need to know after election to the board. A separate commenter stated 
that true cooperative principles mean that any borrower of the 
institution with an acceptable loan should have the right to be 
nominated. Seven commenters remarked on the conflict between 
established qualifications and floor nominations. Two thought the 
requirement was compatible with the outside director selection process 
but was not consistent with the cooperative principles of electing a 
board from its membership. A commenter said that associations already 
struggle with locating willing candidates with loans in good standing 
and our rule will make this task more difficult.
    One commenter noted that a qualification for a director should be 
integrity, not knowledge of financial reporting or risk management. 
Others said that it is the board's responsibility to decide what 
qualifications are needed. A few other commenters said the criteria in 
the rule were too narrow, making it more difficult to fill director 
positions. These commenters expressed concern that we could establish a 
standard that was either irrelevant or could not be met by some 
institutions. Another commenter remarked that it is difficult to 
regulate meaningful standards for candidate education because candidate 
evaluations are subjective. The commenter further explained that 
production agriculture generally offers fewer titles and certifications 
for professional verification, not withstanding strong educational 
backgrounds. This same commenter concluded that our rule would impose 
an unnecessary burden on the nominating committee. Other commenters 
also objected to the inference that institutions conduct director 
recruitment. One of these commenters further stated that we 
demonstrated a lack of respect for the ability of stockholders to 
select qualified directors. One commenter said that we should encourage 
better communications between the board and the nominating committee 
within the confines of the Act.
    Two commenters suggested that the institution identify in their 
bylaws the desirable areas of knowledge and expertise and have the 
nominating committee consider these attributes in searching for 
suitable candidates. Another commenter suggested replacing the 
standards with guidelines, recognizing that the necessary 
qualifications would vary depending on the size, strength, and 
complexity of the institution. We were asked to explain who will set 
the standards and how they will be applied. Commenters stated that 
stockholders must have the ability to determine who among the eligible 
candidates are best qualified to serve. Other commenters suggested that 
the regulatory language be revised to give latitude to the directors to 
articulate their own standards.
    We agree that it is the board's responsibility to establish 
director qualifications. The Act requires bank and association boards 
to identify director qualifications in their bylaws and we proposed 
regulations to implement this provision of the Act. We have clarified 
the rule to clearly state institutions must establish policies 
addressing director qualifications. We also require the policy be 
periodically updated and provided to the institution's nominating 
committee. We make this change in response to commenter concerns for 
flexibility and the cooperative election process.
    We also modified our rule by requiring identification of desirable 
director qualifications as opposed to prescribing them. In preserving 
the board's authority to determine relevant and needed qualifications, 
the identified qualifications must be adequate to meet the board's 
needs but broad enough to allow the nominating committee to identify at 
least two willing and qualified candidates for each open position 
without undue burden or difficulty. We have confidence that boards can 
identify relevant director qualifications for their respective 
institutions even though there is an element of subjectivity. We expect 
that the board's training program will be sufficient to enhance 
directors' skills and qualifications, such as for potential YBS 
directors, so that they can acquire needed skills and qualifications 
for board service. We also removed the suggested areas of experience 
from the final rule. While we proposed them as suggested areas, not 
requirements, commenters generally viewed them as obligatory. We 
address the comment that institutions do not engage in recruitment of 
directors in V.B.3. of this preamble.
    Commenters objected generally to our interpreting the Act, looking 
at legislative history and issuing regulations on board composition, 
remarking that Congress spoke unambiguously and directly to director 
requirements. The FCC pointed out that institutions and their 
nominating committees are obligated to consider all eligible 
stockholders. A few commenters remarked that the Act reflects the 
Congressional intent that the System be governed by popularly elected 
directors without regard to expertise or other qualifications.
    We do not agree that Congressional intent precludes consideration 
of expertise or other qualifications for directors. The Act specifies 
that director qualifications be included in an institution's bylaws. 
While it is the responsibility of the nominating committee to find 
candidates who meet, or potentially will meet through director

[[Page 5747]]

training, board-identified qualifications, this does not preclude the 
nomination of director candidates from the floor or any other eligible 
stockholder from seeking nomination without regard to desirable 
director qualifications. In the end, it is the stockholders who have 
the right to decide, through the balloting process, which candidates 
will best serve their needs.
    We moved the requirement for a board financial expert from Sec.  
611.220 on outside directors to this section of the rule. We address 
comments made on the financial expert proposal and resulting changes in 
the rule in the outside director section of this preamble at V.B.3.a.i.
b. Director Training
    We received 17 System comments on this provision of the rule. Three 
commenters supported the requirement for director training and nine 
others suggested that we require each institution to adopt a policy on 
director training. Three commenters recommended we allow the 
institutions to determine appropriate training and one asked that 
training topics be suggested, not mandatory. Several others suggested 
we simply require director training and development programs, instead 
of specific topics, stating that the rule curtails flexibility in 
determining training needs. One commenter said that the provision is 
unnecessary because director training is already an accepted 
responsibility of the System. Another commenter remarked on the 
difficulty in making a director take training. One commenter agreed 
that training for new directors and their role should be completed 
within the year, but training for other directors should be left to the 
board's discretion. Two commenters stated we have sufficient ability to 
evaluate training when conducting our Capital, Asset quality, 
Management, Earnings, Liquidity, and Sensitivity to market risk 
(CAMELS) review and we can make recommendations when those findings 
occur, eliminating the need for a rule.
    We continue to believe that director training is an essential 
component of good governance and the System's safety and soundness. 
However, we are persuaded by commenters that the facts and 
circumstances of each institution vary sufficiently to make specific 
training requirements useful in some instances and possibly irrelevant 
in others. Consequently, we have amended the rule by eliminating 
reference to specific training topics. We have further modified the 
rule to require the establishment of director training policies and 
implementing procedures. We believe it is more appropriate for 
institutions to identify their own training needs, becoming more 
proactive in considering how to improve their CAMELS review, rather 
than waiting for examiners to identify training deficiencies. We 
encourage institutions to coordinate director training with desired 
director qualifications to facilitate the ability of incumbent 
directors and YBS borrower-director candidates to meet those 
qualifications. The rule retains the requirement that new directors 
receive orientation training within the first year of becoming a 
director and that incumbent directors receive periodic training.
2. Board Evaluations [Sec. Sec.  615.5200 and 618.8440]
    We received 62 System letters generally supporting board self-
evaluations, but 38 stated that a regulatory requirement was 
unnecessary. Fourteen of these stated that institution boards should 
determine their own best practices for self-evaluations, or be allowed 
the flexibility to choose the type and breadth of self-evaluations 
based on local needs. Another 10 commenters were against a rule 
requiring board evaluations, stating that their boards already conduct 
self-evaluations, which are an internal matter, making a regulation 
unnecessary and burdensome. Some commenters also claimed self-
evaluations are redundant since the composition of boards does not 
significantly change. Two expressed concern that the regulatory 
requirement does not specify how board self-evaluations are to be 
conducted, and so may not adequately measure the performance of the 
board. Another commenter expressed concern that the evaluations will 
expose those directors who are slow to catch on or refuse to seek 
training. The FCC characterized the provision as ``arbitrary'' as self-
evaluations alone will not improve a board's effectiveness. They also 
challenged the necessity for the provision based on the actions of 
other regulators, stating they knew of no other regulator requiring 
self-evaluations. They further objected to the provision since no 
recognition of existing safeguards already in place was given, such as 
FCA Standards of Conduct regulations. The FCC contends that without 
this recognition, an implication that ``something more is needed'' is 
made.
    We agree that the institutions should determine the manner of 
conducting self-evaluations, which is why we did not specify the method 
and manner of conducting evaluations. Whatever method is selected, the 
goal of self-evaluations is to help a board identify its strengths and 
weaknesses and improve its own performance, especially in light of 
current and anticipated economic circumstances. Board self-evaluations 
are a tool for boards to enhance their effectiveness and should be 
conducted in a manner that best supports the board's strategic planning 
and oversight responsibilities. In our view, whether or not a board's 
composition changes does not alter a board's performance and does not 
make evaluations of that performance redundant. Even if the board 
composition does not change, the economic circumstances and related 
risks facing each institution change each year, sometimes dramatically. 
We also do not agree that System institution boards should not 
undertake self-evaluations because other regulators do not have similar 
standards; nor do we agree that a regulatory provision is not needed. 
Board self-evaluations are recognized as a best practice and we find 
that board evaluations are a necessary and essential component to an 
institution's strategic plan. Evaluations identifying board strengths 
and weaknesses, opportunities and challenges, and how the board plans 
to address those issues add value to the strategic planning process.
    Commenters stated that regulations on this issue are not necessary 
because FCA already evaluates the effectiveness of management and the 
board in our examination process. These commenters also stated that we 
have the authority to recommend actions when an institution's board of 
directors is not functioning properly without a regulatory provision. 
The fact that we examine a board's effectiveness during an examination 
does not relieve each institution board of the responsibility for its 
own review of its performance. While there are existing safeguards 
present in System operations, none are designed to replicate or obviate 
the need for board self-evaluations as evidenced by the significant 
number of commenters who stated that their institutions are already 
conducting board evaluations. These evaluations are a useful planning 
tool for salaries, board committee membership, training, and other 
areas.
    Other commenters stated that board evaluations do not belong in the 
business plan, but should remain under the control of the board. Some 
of these commenters explained that because the business plan is a tool 
for communicating with senior managers and others, candor in the 
evaluations may be lost. One commenter stated that

[[Page 5748]]

our rule language could be read to be a requirement that the self-
evaluations themselves be included in the strategic plan, expressing 
concern that the value of the evaluations would be lost if widely 
circulated. Others asked us to clarify if the evaluations must be 
included in business plans or if the board can make a general statement 
verifying the evaluations were done. The rule at Sec.  618.8440(b) has 
been modified to clarify that the strategic plan must assess board 
needs based on a review of the annual board self-evaluations. The plan 
does not have to include the self-evaluation itself. We do, however, 
require at Sec.  611.325(c) that a summary of the evaluations be given 
to the institution's nominating committee when requested.
    Thirty-three System commenters expressed concern with the 
requirement that the self-evaluations occur annually. Many suggested 
conducting evaluations every 3 years or, at the most, every other year. 
Others suggested allowing boards to use their discretion to determine 
when and how often self-evaluations are needed. One commenter suggested 
delaying implementation of the rule to give boards time to develop 
meaningful programs, while another explained time was needed to 
implement findings from the previous year. A separate commenter 
advocated a cyclical format instead of a date-specific rule. We 
continue to believe that an annual evaluation is best because it 
coincides with an institution's annual planning and reporting cycle. It 
was for this reason we included consideration of the annual board self-
evaluations as part of the 3-year operational and strategic business 
plan. This combined review is appropriate to ensure a complete 
assessment of the institution's risk environment, its strategic and 
operating plans, and its fiduciary and oversight responsibilities.
3. Outside Directors [New Sec.  611.220]
    In our proposed rule, we referred to recruiting outside directors. 
Several commenters said that System institutions do not recruit 
directors as System institutions must keep a neutral position in 
electing directors. The process for selecting outside directors is not 
subject to the referenced constraints on institution neutrality because 
outside directors are not elected by the voting stockholders but 
appointed by an institution's board. Therefore, referring to 
recruitment of outside directors, as well as conducting recruitments, 
is acceptable. Despite this, we have replaced the term ``recruit'' with 
``select'' in the outside director provision of the rule in response to 
these comments.
    One commenter said our language on outside director eligibility 
could be interpreted as forbidding a current outside director from 
being reappointed for a second term, suggesting we amend the rule to 
state that no candidate for an outside director position may be a 
director of any other System institution. We are not changing our rule, 
but clarify that an outside director may be reappointed for a second 
term as long as he or she has not acquired any of the prohibited 
affiliations with the System beyond that of his or her existing role as 
an outside director for that institution.
a. Expertise and Number
i. Financial Expertise
    We received 161 System comments on requiring an outside director to 
be a financial expert. Thirty commenters agreed with the rule based on 
the current business environment. Commenters agreeing with the rule 
stated, howev