Federal Reserve Changes Policy to Encourage Equity Investments in Banks
With the initial US credit crisis rapidly evolving into a global credit crisis, the US Secretary of the Treasury (the “Secretary”), the G-7, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and other central banks have taken aggressive steps to calm markets and encourage investors to provide needed capital to banks worldwide. While the Secretary’s recent announcement that he plans to make direct equity investments into US banks and bank holding companies has received the most media attention, a recent change of policy by the Federal Reserve will likely have the most lasting and beneficial impact on investor opportunity to invest in the US banking system.
Without great fanfare on September 22, 2008, the Federal Reserve posted on its website its approval of a policy statement on equity investments in banks and bank holding companies. See 12 C.F.R. 225.144. The focus of the revised policy is to encourage noncontrolling minority equity investments in banks and bank holding companies. The Federal Reserve is well aware that historically many minority investors have been reluctant to make investments over a certain percentage ownership because those investments would trigger a finding by the Federal Reserve that the minority investors control the bank or bank holding company and are, therefore, subject to the Bank Holding Company Act, Regulation Y and certain restrictions on the business activities of the minority investors. These concerns account for some of the reasons, for example, that it would have been unthinkable just a few months ago that the holding companies of Goldman Sachs and Morgan Stanley, two of the premier investment banks in the world, would voluntarily become subject to the Bank Holding Company Act by converting their industrial loan companies to commercial banks.
To help banking institutions which desperately need capital, in part as the result of extraordinary drops in the stock markets, growing fears involving liquidity and evidence of rapid declines in consumer and investor confidence in the banking system, the Federal Reserve recognized that its 1982 Policy Statement did not encourage minority investments. The new policy statement will now allow minority investors more representation on the board of directors, more flexibility on investor mix of voting and nonvoting securities, more ability to monitor the investment, more ability to obtain reports, more ability to attend meetings as an observer without vote, and more ability to protect the investment.
The new policy changes directly target the part of the Bank Holding Company Act which focuses on investors who “directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25% or more of any class of voting securities” or “controls in any manner the election of a majority of the directors or trustees of the bank or bank holding company.” The key to understanding the Federal Reserve’s position and investor opportunity is to focus on voting securities and a majority of board representation. It is in those areas that the Federal Reserve is signaling that it is willing to provide investor flexibility without triggering a control determination so long as the investor stays under 25% in voting securities and does not have the right to elect a majority of the board of directors. This is important because in the past the Federal Reserve would generally make a control determination if the minority investor had at least one director on the board of directors and the minority investor owned between 10% and 24.9% of the voting stock. The only exception to such a determination was when the minority investor owned less than 15% and another person owned a larger block than the minority investor.
Historically, minority investors have used, and the Federal Reserve has accepted, at least five different methods to make certain that they did not trigger a control determination. First, counsel has advised minority investors to restrict the size of their voting and total equity investments. Those restrictions varied on a sliding scale with the understanding that the greater the size of the investment the greater the risk of a control determination. In general, many banking attorneys are comfortable advising that investments below 5% in voting securities are low risk, investments in voting securities over 5%, but below 15% are moderate risk and investments above 15%, but below 25% are the greatest risk of a control determination. Second, counsel has advised minority investors to avoid covenants that would enable the investor to restrict the ability of the banking institution’s management to determine major policies and operations. The concern is that the Federal Reserve will deem the investor to be a control person or have a controlling influence because notwithstanding the size of the investment, the investor essentially determines important policies and operations of the banking institution. Third, counsel has advised that minority investors refrain from attempting to influence the banking institution’s process for making decisions about major policies and operations. This is closely related to the second admonition except that in this case the focus is on the process rather than the outcome. Fourth, counsel has advised minority investors to limit director and officer interlocks. This means that minority investors must be careful about having officers or directors of the minority investors also serving as officers or directors of the banking institution. Fifth, counsel has advised the minority investors to limit business relationships between the minority investor (e.g., the company that actually owns the investment) and the banking institution. This means that minority investors must be careful about any contracts between the minority investors and the banking institution or any credit arrangements. With that background the Federal Reserve focuses on five areas where it encourages minority investors to take a close look at the new opportunities.
First, the Federal Reserve is willing to allow minority investors to increase the number of board representatives without triggering a control determination where the minority investor’s aggregate director representation is proportionate to its total interest in the banking institution, but does not exceed 25% of the voting members of the board of directors and another shareholder is a control person. The Federal Reserve is comfortable in this situation because it believes that the control shareholder is a check on the influence of the minority investor. When considering board representation, however, minority investors should know that the Federal Reserve’s position would be different if the board representative is the chairman of the board of directors or is a chairman of a committee of the board of directors.
Second, with the caveat that the larger the size of the investment, the more likely the Federal Reserve will reach a different result, the Federal Reserve is willing to be flexible with the total equity, particularly the nonvoting securities. The change of heart by the Federal Reserve is based upon its view that nonvoting equity does not provide the holder with voting rights that allow direct participation in the selection of management or the decision making process, the law defines control in terms of 25% voting securities and the ability of an investor to exercise control through nonvoting securities depends upon the nature and extent of the investor’s overall investment and the capital structure of the banking institution.
Third, the Federal Reserve is willing to allow minority investors to have more communication and consultation with the banking institution than in the past. So long as the ultimate decision is left, as appropriate, to the shareholders as a group, the board of directors or management, minority investors may, for example, advocate with bank management for changes in bank policies and operations, including, its dividend policy, its strategies for raising debt or equity financing, its expansion into new lines of business or divestiture of a subsidiary, engaging in a merger or even selling the banking institution to an acquirer. In this area, however, minority investors must make certain they do not threaten to sell their shares or engage in a proxy solicitation should the banking institution decide against the position of the minority investor. Such a threat, directly or indirectly, will lead to a control determination.
Fourth, in certain instances, unlike in the past, the Federal Reserve is now willing to allow minority investors to have a material transaction or relationship with the banking institution without triggering a control determination. The Federal Reserve’s concern has always been that by virtue of the importance of the transaction or the relationship to the banking institution, the minority investor would have a controlling influence. The Federal Reserve is willing to make a case by case determination rather than assuming that in all such cases a controlling influence exists. In making its determination the Federal Reserve will take into account the size of the business relationship, whether the business relationship is on market terms, whether the business relationship is non-exclusive and whether the relationship is terminable by the banking institution without penalty.
Fifth, with a great deal of caution, the Federal Reserve has indicated that it will be more flexible with certain covenants. For example, the Federal Reserve indicated that covenants and agreements that prohibit the banking institution from issuing senior securities or borrowing on a senior basis, modifying the terms of the investor’s security or liquidating the banking institution will not trigger a control determination. Similarly, the Federal Reserve has indicated that a covenant that requires the banking institution to provide the minority investor with rights to limited financial information and consultation will not trigger a control determination. The Federal Reserve also pointed out, however, that it continues to have a concern about minority investor covenants or contractual terms that restrict the banking institution’s ability to hire, fire, and compensate executive officers; engage in new business lines or make substantial changes to its operations; raise additional debt or equity capital; merge or consolidate; sell, lease, transfer, or dispose of material subsidiaries or major assets; or acquire significant assets or control of another firm. These covenants will trigger a control determination.
The Federal Reserve’s new policy is great news for investors who are interested in investing in banking institutions without triggering a control determination. Attorneys at Troutman Sanders regularly assist clients with these types of investments. Our lawyers have extensive experience in helping our clients navigate through the maze of regulatory requirements of the Federal Reserve and the other regulatory agencies. Should you decide to consider such an investment and need assistance, please contact a member of the Financial Institutions Group.
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