In December 2015 (following years of sporadic and seemingly random criticism) of shareholder protection arrangements, the Board of Governors of the Federal Reserve System issued guidance that the Federal Reserve “may” object to a shareholder protection agreement based on the facts and circumstances and the features of the particular arrangement. Federal Reserve Supervisory Letter SR 15-15 does not require submission of such arrangements to the Federal Reserve for comment prior to implementation, but rather directs institutions considering the implementation or modification of such arrangements to “review this guidance to help ensure that supervisory concerns are addressed.”
Supervisory Letter SR 15-15 casts a long shadow, with little clarity as to the line between acceptable and unacceptable arrangements. SR 15-15 sites a wide array of potentially objectionable shareholder protection arrangements, but then indicates that supervisory staff has “in some instances” found that these arrangements would “have negative implications on a holding company’s capital or financial position, limit a holding company’s financial flexibility and capital-raising capacity, or otherwise impair a holding company’s ability to raise additional capital.” Presumably speaking only of these particular arrangements (although not clearly so stating), SR 15-15 states “[t]hese arrangements impede the ability of a holding company to serve as a source of strength to its insured depository subsidiaries and were considered unsafe and unsound.”
SR 15-15 provides a number of examples of categories of shareholder protection arrangements that have (sometimes) raised supervisory issues. Some of these examples are entirely consistent with past Federal Reserve precedent and are generally impermissible in bank-related investments, including price protections in offering arrangements whereby a holding company agrees to a cash payment or additional shares to the investor in the event that additional shares are issued in subsequent transactions at lower prices. These “down-round” provisions have always been viewed by the Federal Reserve as acting as an impermissible disincentive (and potential disabling mechanism) for a holding company to raise additional capital going forward. (In a surprising move of clarity, the Federal Reserve guidance does, by footnote, specifically indicate that preemptive rights, or the right to participate in subsequent offerings to prevent dilution of ownership, does not, in general, raise any supervisory concerns.)
However, the examples also extend significantly further to potentially capture a wide array of shareholder agreements, including those frequently used to preserve Subchapter S eligibility, and certain arrangements commonly entered into to protect deferred tax assets from undergoing an “ownership change” under Section 382 of the Internal Revenue Code.
As an example of a shareholder protection arrangement that has raised supervisory concerns, Supervisory Letter SR 15-15 identifies provisions whereby the holding company’s board of directors has the authority to nullify share purchases under certain circumstances, require the holding company to repurchase the shares of the company from a new owner of the shares, or take other actions that would significantly inhibit secondary market transactions in the shares of the holding company. SR 15-15 further notes that these arrangements could include prohibitions on share transfers, as well as buy-sell agreements, rights of first refusal and similar arrangements that “sufficiently restrict the transfer of shares as to effectively prohibit most, if not all, transfers.”
Of course many privately held bank holding companies, including but not limited to Subchapter S institutions, have a strong desire to remain privately held. Particularly in Subchapter S institutions, shareholder agreements are frequently used to provide a contractual agreement amongst the shareholders to preserve the institution’s eligibility for Subchapter S tax treatment. These arrangements often prohibit transfers to non-eligible shareholders and can provide rights of first refusal or other similar provisions in favor of the holding company and/or other shareholders.
Our conversations with Federal Reserve staff, however, indicate that SR 15-15 is NOT intended to address restrictions designed to preserve Subchapter S eligibility, and should not be used by examiners to criticize these types of provisions.
Deferred Tax Asset Preservation
Particularly in light of the great recession, we’ve seen a number of bank holding companies, including several clients, implement protections designed to prevent an inadvertent “ownership change” under Section 382 of the Internal Revenue Code. When an “ownership change” is triggered under Section 382, deferred tax assets become subject to a potentially significant annual limitation in their recognition, which can cause not only a delay in ability to utilize net operating losses, but also a permanent loss some or all of the deferred tax asset.
Generally, bank holding companies have implemented two approaches to prevent an inadvertent “ownership change” under Section 382 of the Internal Revenue Code: a shareholder rights plan (or tax benefit preservation plan) and a transfer restriction. The shareholder rights plan, much like a more traditional poison pill, does not prevent an “ownership change” directly but rather provides a significant economic disincentive from the acquisition of more than 4.9% of the outstanding shares of the bank holding company (at least without the approval of the institution’s board of directors). The transfer restrictions operate under state law provisions to attempt to prevent (and treat as void ab initio) any transfer which would cause the resulting shareholder to own more than 4.9% of the outstanding shares. In our experience, these provisions work best together; the threat of the economically disastrous shareholder rights plan encourages all involved to respect the transfer restrictions under state law.
Supervisory Letter SR 15-15 indicates that the Federal Reserve’s objection is that these provisions restrict “in some way” the primary or secondary market for the holding company’s shares, and serve “to protect the value of the initial investment made by a particular subset of shareholders rather than the viability of the issuing holding company.”
It is true, of course, that these restrictions limit the secondary market; much like securities law for private stock issuances, the Treasury’s restrictions on eligible participants in TARP auctions, and the Federal Reserve’s Change in Bank Control Act regulations each also limit the secondary market for holding company stock. However, often preserving the deferred tax asset is far from a limitation on the institution’s ability to raise capital. Rather, preserving the deferred tax asset is absolutely critical to the institution’s ability to raise capital; sometimes representing significantly more value than the institution on a stand alone basis.
As the deferred tax asset does not constitute regulatory capital, we have generally found the banking regulators to be indifferent to its preservation. However, the deferred tax asset is included in tangible capital, and it’s future use can effectively shield future income from taxes, thereby increasing the institution’s potential return on equity going forward. Of course, either higher tangible capital or a higher return on equity (and certainly both together) make it easier for a holding company to “raise additional capital” and to “serve as a source of strength.” Neither of these arrangements “impede the ability” of the holding company to serve as a source of strength.
Particularly in the event that any investors seek a passivity commitment with the Federal Reserve and the deferred tax asset preservation approaches are noted in the securities purchase agreement, we expect the Federal Reserve to continue to review (and comment upon) these shareholder protection arrangements. These arrangements are often poorly understood by the regulators … and by the gatekeepers that attempt to explain their benefit on behalf of the institution. In light of SR 15-15, every institution looking at implementing these types of arrangements should be comfortable that they, and anyone speaking with the regulators on their behalf, understand the restrictions imposed by these arrangements, the rationale for imposing such restrictions, and perhaps most importantly, the exceptions to these restrictions. Emphasizing the ability of the institution’s board of directors to terminate these arrangements (or otherwise approve exceptions) is, in our opinion, critical to obtaining regulatory buy-in on these arrangements. We have also, in at least one instance, obtained approval for such provisions after adding a termination event whereby the arrangements automatically terminated if an applicable bank regulatory agency determined that the arrangement was inhibiting the ability of such institution to raise capital that was necessary to satisfy a regulatory capital standard in the future. While such a termination event should be unnecessary, it is also unlikely to be triggered for any number of reasons, and would seem to be an easy concession to gain regulatory acceptance.
Discussions with Federal Reserve staff indicate that SR 15-15 was issued, at least in part, to give management “some ammunition” to push back on investors, particularly private equity investors, on provisions that the Federal Reserve has historically found troublesome.
Particularly with regard to Subchapter S and tax preservation approaches, I believe this is a misreading of the source of such provisions. Often it is management, rather than private equity investors, that are proposing these restrictions, recognizing that such restrictions put the institution in the best position going forward to raise capital and thrive.
Moreover, the breadth of the guidance also provides ammunition to investors to push back against management on any restrictions that may be viewed to inhibit secondary market transactions. Provisions related to registration rights, Rule 144A, legend removals and more all serve to facilitate secondary market transactions, which, per SR 15-15, now appear to be viewed by the Federal Reserve as instructive to the ability of a holding company to serve as source of strength to its depository institutions.