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Federal Reserve Eases Limitations on Controlling Investments in Banking Organizations
September 24, 2008
On Monday, September 22, 2008, the Board of Governors of the Federal Reserve System (the "Federal Reserve") released a policy statement easing certain requirements that would cause an investor in a bank or bank holding company to become subject to supervision and regulation under the Bank Holding Company Act of 1956, as amended, and the Federal Reserve's Regulation Y (12 C.F.R. Part 225). The policy statement loosens rules that generally limit private equity and hedge fund investments in banking organizations.
Under the policy statement, investors may (i) acquire up to one-third of the outstanding voting securities of a banking organization provided that the investment includes only 15% of the outstanding voting securities of any class, (ii) appoint up to two directors of the banking organization (subject to ownership percentage and other limitations), and (iii) engage in expanded communications and discussions with management of a banking organization, and not have to register as a bank holding company.
Registration as a Bank Holding Company: Historically, the Bank Holding Company Act and regulations promulgated thereunder by the Federal Reserve have limited the ability of unregistered investors, including private equity firms and hedge funds, from taking significant stakes in banking organizations. Under the Bank Holding Company Act, an investor must register as a bank holding company in order to own more than 24.9% of the outstanding voting interests of a banking organization. An investor could also be deemed to be a bank holding company if it exercises a controlling influence over the management or policies of the banking organization.
Registration as a bank holding company brings supervision and examination by the Federal Reserve, reporting obligations as well as restrictions on the investor's activities and other investments. Further, an investor deemed to be a bank holding company also could be forced to serve as a "source of strength" for the banking organization which could expose the investor to significant loss beyond its original equity investment. These downsides have significantly limited banking organizations' access to capital markets, including, particularly, funds from hedge funds and the private equity industry.
New Interpretation of Controlling Interest: Under the new policy statement, the Federal Reserve addresses its interpretation of what constitutes a controlling interest of a banking organization. The policy statement eases the limitations on the size of minority investments that could be deemed to have a controlling influence over a banking organization. The Federal Reserve recognizes that an investor's ability to exercise a controlling influence through nonvoting equity instruments depends "significantly on the nature and extent of the investor's overall investment in the banking organization and on the capital structure of the banking organization."
Increased Allowable Ownership Percentage: In past practice, to avoid a control determination by the Federal Reserve and bank holding company status, an investor generally has been limited to a voting equity ownership interest of less than 10% when also seeking to appoint even one director of the banking organization. Even a non-voting stake typically was limited to a 15% threshold.
However, under the new policy statement the Federal Reserve provided guidance that a minority investor may hold up to an aggregate of 33% of the outstanding equity interests of a banking organization provided that the investor does not own, hold or vote 15% or more of any class of voting securities of the organization.
Board Representation of Investors: The policy statement also states that the Federal Reserve has reversed its previous position and that it now believes that a minority investor should be able to have representation on the board of directors of a banking organization without being deemed to be exercising a controlling influence over the management and policies of the banking organization. Under the policy statement, a minority investor may appoint a member of the board of directors of a banking organization. An investor may also appoint up to two directors to the board of a banking organization, provided that the aggregate director representation is proportionate to the investor's total interest in the banking organization and such representation does not exceed 25% of the voting members of the Board, and provided further that there is another stockholder that has a controlling interest in the banking organization. The minority investor's appointed directors may serve on board committees, but the representation on a committee may not exceed 25% of the committee membership and the appointed directors may not have the practical authority to make or block decisions of the committee. Also, a minority investor's appointed director may not serve as the chairman of the board of the banking organization or chairman of a committee of the board.
Expanded Communications with Management: Minority investors previously have been limited in the types of communications and interactions with banking organizations severely restricting their abilities to influence in any manner the activities of the banking organization. The new policy statement provides guidance and expands the types of communications that minority investors may have with management that are consistent with noncontrolling investments. According to the policy statement, "The Board believes that a noncontrolling minority investor, like any other shareholder, generally may communicate with banking organization management about, and advocate with banking organization management for changes in, any of the banking organization's policies and operations. For example, an 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; or attempt to convince banking organization management to merge the banking organization with another firm or sell the banking organization to a potential acquirer."
Investor Commitments: In the past, the Federal Reserve has required minority investors to make certain written commitments (i.e., the CrownX and Lincoln commitments) in connection with and as a condition to the making of the investment. The commitments typically focused on maximum ownership percentages, director representation, communications with management and the other key issues discussed in the policy statement. The Federal Reserve likely will continue to require that minority investors make written commitments to the Federal Reserve, but, due to the changes in position discussed in the policy statement, the commitments likely would be revised in substance to be consistent with the new positions of the Federal Reserve. For example, instead of committing "not to seek or accept any representation on the board of directors of the banking organization" or "not to attempt to influence the dividend policies or practices of the banking organization", the minority investor instead would commit "not to accept any representation on the board of directors of the banking organization in excess of 25% percent of the positions on the board or in excess of such shareholder's percentage ownership of the banking organization" or "may advocate for changes in the dividend policies and practices of the banking organization but not in a manner that creates a threat to the banking organization."
Conclusion: The new policy statement should facilitate investments in banking organizations seeking increasingly important capital infusions and allow investors, including private equity and hedge fund investors, to take a more active role in the affairs of a banking organization while still avoiding designation as a bank holding company. In light of the ongoing rapid changes in the banking industry, structuring investments into banking organizations will require care and interaction with bank regulatory agencies and advice from experienced legal counsel.