Federal Reserve Board Policy Statement On Equity Investments In Banks And Bank Holding Companies - Private Equity & MBO's

Originally published September 24, 2008

Keywords: federal reserve board, policy statement, equity investments, BHCs, banking organizations, private equity, nonbank investors, Bank Holding Company Act, BHCA

On September 22, 2008, the Board of Governors of the Federal Reserve System (Board) released a policy statement (Policy Statement) that liberalizes to some extent the ability of investors to make noncontrolling equity investments in US commercial banks and bank holding companies (BHCs) (collectively "banking organizations"). The Policy Statement provides useful guidance and relief to private equity and other nonbank investors with respect to the extent to which they can have director interlocks with, make equity investments in and communicate with management of banking organizations without becoming subject to the Bank Holding Company Act of 1956, as amended (BHCA).¹

The changes reflected in the Policy Statement will help facilitate broader involvement by private equity funds and other minority investors in the banking industry, as well as the ability of BHCs to partner with such entities in making joint investments in other banking organizations. However, the Policy Statement also confirms many of the Board's traditional positions on control relationships that trigger application of the BHCA. The determination of whether an investor has the ability to exercise a "controlling influence" will continue to require an analysis of all of the relevant facts and circumstances and, in some cases, consultation with the Board.

The Policy Statement also applies to equity investments by BHCs in nonbanking companies, liberalizing the extent to which BHCs and foreign banking organizations can make equity investments in nonbanking companies without being deemed to control those entities for purposes of the nonbanking restrictions in Section 4 of the BHCA. The Policy Statement does not, however, address "control" questions raised by minority investments under the Change in Bank Control Act of 1978.

The full text of the Board's policy statement is available at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20080922b1.pdf.

Principal Changes Made By The Policy Statement

DIRECTOR INTERLOCKS

Prior to the issuance of the Policy Statement, the Board generally has not permitted a company that acquires between 10 and 24.9 percent of the voting stock of a banking organization to have representation on the organization's board of directors. The principal exception to this guideline has been in situations in which the investor owned less than 15 percent of the banking organization's voting stock and another person (or group of persons acting together) owned a larger block of the organization's voting stock.

The Policy Statement provides significant new guidance in this area, stating that:

A minority investor (who may hold up to 33 percent of the banking organization's equity) generally should be able to have a single representative on the board of directors of a banking organization, absent other indicia of control; thus, the Policy Statement removes the prior percentage-of-shares restrictions on the right of a minority investor to have a director representative;
A minority investor generally should be able to have up to two representatives on the banking organization's board of directors, absent other indicia of control, when the two directors are proportionate to the investor's total interest in the banking organization, but do not exceed 25 percent of the voting members of the board, and another shareholder of the banking organization is a BHC that controls the banking organization under the BHCA;
A representative of a minority investor that serves on the banking organization's board of directors should not serve as either the chairman of the board or the chairman of a committee of the board of the banking organization; and
Representatives of a minority investor may serve on committees of the banking organization's board when those representatives do not occupy more than 25 percent of the seats on any committee and do not have the authority or practical ability unilaterally to make (or block the making of) policy or other decisions that bind the board or management of the banking organization.

These changes will expand the ability of private equity funds and other investors to have a voice on a banking organization's board of directors without being deemed to exercise a controlling influence over the banking organization. These changes also should facilitate partnering between, for example, a private equity fund and another BHC, so long as the BHC investor controls the banking organization.

COMMUNICATIONS WITH MANAGEMENT

Prior to the Policy Statement, the Board had provided little guidance on the extent to which consultations between a passive investor and management of the banking organization in which the investment was made would be consistent with a "noncontrol" determination, although it informally signaled some level of discomfort with the occurrence of such communications.

The Policy Statement provides that a noncontrolling minority investor may communicate generally with banking organization management about, and advocate with management for changes in, any of the banking organization's policies and operations. The Policy Statement provides greater certainty to private equity funds and other investors about the extent to which they can advise a banking organization without being deemed a "nonpassive" investor. Specifically, the investor may directly or through a representative on a banking organization's board of directors:

Advocate for changes in the banking organization's dividend policy;
Discuss strategies for raising additional debt or equity financing;
Argue that the banking organization should enter into or avoid a new business line or divest a material subsidiary;
Attempt to convince banking organization management to merge the banking organization with another firm or sell the banking organization to a potential acquirer; or
Advocate changes in the banking organization's management and recommend new or alternative management.

The decision to adopt a particular position or take a particular action must remain with the banking organization's shareholders as a group, its board of directors or its management, as appropriate. Minority investors should not make explicit or implicit threats to dispose of shares in the banking organization or to sponsor a proxy solicitation as a condition of action or non-action by the banking organization or its management on any recommendation made by the investor.

EQUITY INVESTMENTS

Prior to the issuance of the Policy Statement, the Board's general position was that nonvoting equity investments that exceed 25 percent of the "total equity" of a banking organization raise control issues under the BHCA. The Policy Statement now recognizes the conditional ability of an investor to acquire up to 33 percent of total equity without the investor having a controlling influence over a banking organization.

An investor may own a combination of voting shares and nonvoting shares that, when aggregated, constitute less than one-third of the total equity of the organization (and less than one-third of any class of voting securities, assuming conversion of all convertible nonvoting shares held by the investor). Such an investor may not own, hold or vote 15 percent or more of any class of voting securities of the organization. Thus, a private equity fund may hold up to 33 percent of the equity of a banking organization without being deemed, on that basis alone, to exercise a controlling influence over the bank.

General Restatement Of Current Board Guidance As To The Existence Of A "Controlling Influence" Over A Banking Organization

The Board's traditional position has been that the determination of whether an equity investor in a banking organization has a controlling influence over the management or policies of the banking organization requires an analysis of the facts and circumstances surrounding the investor's investment in, and relationship with, the banking organization. The Policy Statement reaffirms this position and, in certain respects described below, provides slightly expanded general guidance.

PASSIVITY COMMITMENTS AS A GENERAL MECHANISM TO AVOID CONTROL

Under existing guidance, equity investments exceeding 9.9 percent of voting interests in a banking organization have typically been accompanied by a set of passivity commitments (sometimes referred to as "Crown X" commitments) that are designed to prevent a company from exercising a controlling influence over the target banking organization.² Subject to the modifications discussed above, the Policy Statement reaffirms the continued viability of the traditional passivity commitments.

OTHER POTENTIAL INDICIA OF CONTROL

Business Relationships

The Board traditionally has prohibited a noncontrolling minority investor in a banking organization from having any material business transactions or relationships with the banking organization, but has frequently allowed business relationships that were quantitatively limited and qualitatively nonmaterial, particularly in situations where an investor's voting securities percentage in the banking organization was closer to 10 percent than to 25 percent.

The Policy Statement provides general guidance with respect to business relationships between a minority investor and a banking organization. It states that the Board continues to believe that business relationships should remain limited and that the Board will continue to review business relationships on a case-by-case basis within the context of the other elements of the investment structure. In that review, the Board will pay "particular attention" to the size of the proposed business relationships and to whether the proposed business relationships would be on market terms, non-exclusive, and terminable without penalty by the banking organization.

Permissibility Of Covenants To Take Or Refrain From Taking Action

The Board's view has historically been that covenants that substantially limit the discretion of a banking organization's management over major policies and decisions suggest the exercise of a controlling influence. The Policy Statement highlights the Board's continuing concern regarding covenants or contractual terms that place restrictions on, or otherwise inhibit, the banking organization's ability to make decisions about the following actions:

Hiring, firing and compensating executive officers;
Engaging in new business lines or making substantial changes to the organization's operations;
Raising additional debt or equity capital;
Merging or consolidating;
Selling, leasing, transferring or disposing of material subsidiaries or major assets; or
Acquiring significant assets or control of another firm.

The Policy Statement also confirms that the Board generally does not view as problematic for control purposes those covenants that give an investor rights permissible for a holder of "nonvoting securities," as that term is defined in section 225.2(q)(2) of Regulation Y (12 C.F.R. § 225.5(q)(2)), including covenants that prohibit the banking organization from:

Issuing senior securities or borrowing on a senior basis;
Modifying the terms of the investor's security; or
Liquidating the banking organization.

Finally, the Policy Statement notes that noncontrolling covenants also could include covenants that provide the investor with limited financial information rights and limited consultation rights.

Convertible Interests

The Board's general policy has historically been that nonvoting shares that are convertible into voting shares at the election of the holder of the shares, or that mandatorily convert after the passage of time, should be considered voting shares at all times for purposes of the BHCA. The Policy Statement reaffirms this position, and notes that nonvoting shares that are convertible into voting shares carry "less influence" when the nonvoting shares may not be converted into voting shares in the hands of the investor and may only be transferred by the investor:

To an affiliate of the investor or to the banking organization;
In a widespread public distribution;
In transfers in which no transferee (or group of associated transferees) would receive 2 percent or more of any class of voting securities of the banking organization; or
To a transferee that would control more than 50 percent of the voting securities of the banking organization without any transfer from the investor.

Conclusion

For some time, the banking industry and private equity markets, which have asserted that the existing Board rules for minority investments were too restrictive and discouraged the contribution of desirable capital to US banking organizations, have awaited the Board's liberalization of its rules for minority investments in banking organizations. The full impact of the Policy Statement in facilitating the investment of capital in banking organizations of course will have to play out over the coming months and years. The Policy Statement, however, liberalizes certain numerical and qualitative restrictions and therefore provides further flexibility to investors to make substantial investments in banking organizations without becoming subject to the burdensome requirements and restrictions of the BHCA. For example, it is now possible for a minority investor to have a 33 percent stake in a banking organization and have two director representatives on the banking organization's board, which represents a meaningful change from prior Board rules. The Policy Statement also permits such investors to play a greater role in the business affairs of such organizations without being deemed to be exercising an undue influence.

At least two basic concerns, however, remain unaffected by the Policy Statement. First, the Policy Statement did not – and, of course, could not – change the basic BHCA statutory thresholds for banking organization "control," such as ownership or control of 25 percent or more of a class of voting shares of a banking organization, which will continue to have an inhibiting effect on outside investments in banking organizations. Second, the Policy Statement made it clear that the determination of the presence or absence of "control" through a "controlling influence" still is very much a facts-and-circumstances inquiry that does not lend itself to a statement of broad principles of control or non-control. The Board has clarified certain instances in which a controlling influence would or would not exist, but in doing so it has not removed other areas where uncertainty still exists. On balance, the Policy Statement will provide incremental relief to banking organizations seeking capital and investors wanting to provide it, but it is not a fundamental realignment of the Board's rules for such investments.

While this Update describes the new Policy Statement of the Board with respect to equity investments in banking organizations, we note that there have been ongoing discussions among the Board, the US Department of the Treasury and various other government agencies as to whether and how the existing framework should be modified by statute or regulation to allow for greater equity investment in these institutions. We are monitoring these developments and will provide additional guidance as appropriate.

Learn more about our Financial Services Regulatory & Enforcement practice.

Footnotes

1. Section 3 of the BHCA requires that a company must obtain approval from the Board before acquiring control of a banking organization. Under the BHCA, "control" means (i) ownership or control of 25 percent or more of any class of voting securities of the banking organization, (ii) control over the election of a majority of the board of directors of the banking organization and (iii) the ability to exercise a "controlling influence" over the management or policies of a banking organization. The Policy Statement primarily addresses the issue of what constitutes a "controlling influence."

A BHC is expected to serve as a "source of strength" for the banking institution, and is subject to continuing supervision by the Board, as well as to the BHCA's general prohibition on the conduct of nonbanking activities by a BHC. These factors have been a significant impediment to investment by private equity and other investors who wanted to make equity investments in banking organizations but were not prepared to become BHCs.

2. The Crown X commitments prevent an investor from exercising a controlling influence by, for example, imposing restrictions on the size of the investor's voting and total equity investment in the banking organization, requiring that the investor avoid covenants that would enable the investor to restrict the ability of the banking organization's management to determine the major policies and operations of the banking organization, and limiting director and officer interlocks with the banking organization.

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United States: Federal Reserve Board Policy Statement On Equity Investments In Banks And Bank Holding Companies