Changes Ease Rules on Non-Controlling Equity Investments in Banking Organizations
On September 22, 2008, the Board of Governors of the Federal Reserve System (“Board” or “Federal Reserve”) issued a long awaited Policy Statement on Equity Investments in Banks and Bank Holding Companies. 1/ The Policy Statement somewhat eases the restrictions that have hampered private equity and other minority investors’ ability to make investments in banks and bank holding companies without being deemed to control those organizations under the Bank Holding Company Act (“BHC Act”). The three main revisions to the Federal Reserve’s precedent that will provide additional flexibility are (1) the ability for investors holding between 15 percent and 24.9 percent of a class of voting securities of a banking organization to have a representative on the board of directors, and in some cases two representatives; (2) increased permissible levels of non-voting equity investments from 25 percent of the total equity to 33 percent in certain instances; and (3) an increased ability for a minority investor to communicate with management and advocate for specific policies.
The BHC Act requires any company that directly or indirectly controls a bank or a bank holding company to register as a bank holding company. 2/ Bank holding companies are subject to the BHC Act’s activity restrictions aimed at separating banking and commerce, and the Fed’s comprehensive regulation and supervision, including consolidated organization capital adequacy requirements, serving as a source of strength to the bank, and the requirement to gain the Fed’s prior approval to make certain investments or engage in certain activities. These restrictions typically are not consistent with a private equity or minority investor’s other businesses and investments. Thus, many minority investors in banking organizations structure their investments in banking organizations to ensure that they are not deemed to be in control of the banking organization.
The BHC Act defines control as (1) directly or indirectly owning, controlling or having the power to vote 25 percent or more of any class of voting securities of a bank or bank holding company; (2) controlling in any manner the election of a majority of the directors or trustees of the bank or bank holding company; or (3) directly or indirectly exercising a controlling influence over the management or policies of the bank or bank holding company that the Board, after notice and opportunity for hearing, determines is control. The Board has a great deal of discretion under the third prong of the control definition to determine whether the investor is in fact in control. In order to rebut a presumption of control, companies making greater than 10 percent minority investments (and in some cases greater than five percent investments) traditionally have entered into a fairly standard set of passivity commitments. Companies making a 10 percent or greater but less than 15 percent investment in class of a banking organization’s voting stock have typically entered into the so-called Lincoln National commitments, and companies making a 15 percent or greater but less than 25 percent investment have typically entered into the so-called Crown-X commitments. Both sets of commitments are similar, and include commitments from the investor that it will not:
- propose a director or slate of directors in opposition to a nominee or slate of nominees proposed by the management or board of directors of the banking organization or any of its subsidiaries;
- solicit or participate in soliciting proxies with respect to any matter presented to the shareholders of the banking organization or any of its subsidiaries;
- attempt to influence the dividend policies; loan, credit, or investment decisions or policies; pricing of services; personnel decisions; operations activities, including the location of any offices or branches or their hours of operation, etc.; or any similar activities or decisions of the banking organization or any of its subsidiaries;
- dispose or threaten to dispose of shares of Bank in any manner as a condition of specific action or non-action by the banking organization; or
- enter into any other banking or nonbanking transactions with the banking organization or any of its subsidiaries, except that investor may establish and maintain deposit accounts with the banking organization, provided that the aggregate balance of all such deposit accounts does not exceed $500,000 and that the accounts are maintained on substantially the same terms as those prevailing for comparable accounts of persons unaffiliated with Bank.
In addition, under the Crown-X commitments, an investor would commit that it would not acquire 25 percent or more of the banking organization’s voting shares and not accept any representation on the board of directors. Under Lincoln National commitments the investor would commit that it would not acquire 15 percent or more of the banking organization’s voting shares, not become the banking organization’s largest shareholder, and limit its representation on the board of directors to one member.
Increased Representation on Board of Directors
The Policy Statement greatly relaxes the limitations the Federal Reserve has traditionally placed on board of directors representation by an investor seeking a non-control determination. Previously, an investor was permitted one board representative if the investor committed to control less than 15 percent of the voting stock and not be the largest shareholder. Generally, no board representation was permitted if the investor held 15 percent or more of the voting stock. Under the Policy Statement, a minority investor generally should be able to have a single representative on the board of directors without being deemed to have acquired a controlling influence over the management or policies. The Board noted that “in the absence of other indicia of control, it would be difficult for a minority investor with a single board seat to have a controlling influence over the management or policies of the banking organization.”
The Policy Statement also allows for the possibility of two board representatives. The Board stated that a minority investor that has up to two representatives on the board of directors is unlikely to exercise a controlling influence over the banking organization, absent other indicia of control, if
- the investor’s aggregate director representation is proportionate to its total interest;
- the investor’s two representatives do not comprise more than 25 percent of the voting members of the board; and
- another shareholder is a bank holding company that controls the banking organization under the BHC Act.
The Policy Statement reiterated the Board’s belief that a minority investor’s board representative should not serve as the chairman of the board or as the chairman of a committee, but provided that representatives of a non-controlling minority investor may generally serve as members of committees. Those representatives may not occupy more than 25 percent of the seats on any committee.
Increased non-voting equity stakes
Since at least 1982, the Federal Reserve has generally viewed non-voting equity investments that exceed 25 percent of the total equity of a banking organization as raising a sufficient controlling influence that such an investor would likely be deemed in control of the banking organization. The Policy Statement reiterated that general view, but provided more flexibility in the use of non-voting equity interests. The Board now believes that in most instances an investor that owns a combination of voting shares and nonvoting shares that represent less than one-third of the total equity would not result in a controlling influence, provided the investor owns or holds with the power to vote less than 15 percent of any class of voting securities.
The Board also reiterated its view that non-voting shares that may be converted into voting shares at the election of the holder of the shares, or that mandatorily convert after the passage of time will continue to be considered voting shares for purposes of the BHC Act. However, the Board reaffirmed its view that for purposes of its control analysis non-voting shares that are not convertible in the hands of the holder would not be viewed as voting stock if the shares 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 two 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.
These so-called dribble-out commitments minimize the investor’s ability to exercise a controlling influence over the organization or to convey control to another party.
The Policy Statement also provided clarity and more flexibility surrounding permissible communications between a minority investor and the banking organization. Prior to the issuance of the Policy Statement, Investors subject to either the Lincoln National or Crown-X commitments agreed that they would not attempt to influence the dividend policies; loan, credit, or investment decisions or policies; operations activities; solicit proxies; or threaten to sell their shares as a way to influence such policies. The Policy Statement clarifies the Board’s view that a non-controlling minority investor, like any other shareholder, generally may communicate with banking organization management to advocate for changes in, any of the banking organization’s policies and operations, such as dividend policy; mergers, and new or alternative management.
The Federal Reserve will continue to review non-control determinations on a case-by-case basis. Despite some commentary that has implied otherwise, there is no “safe harbor” for investments under 15 percent. The Federal Reserve will continue to require that investors holding more than 10 percent of the voting stock of a banking organization enter into passivity commitments reflecting the positions taken in the Policy Statement. Among the items that will likely be closely reviewed are business relationships between the investor and the banking organization, and restrictive covenants.
The Board continues to believe that business relationships between an investor and the banking organization could result in a controlling influence over the banking organization. Therefore business relationships should remain limited if an investor wants to receive a non-control determination. In its review of proposed business relationships, the Board may be comfortable with business relationships that are quantitatively limited and qualitatively nonmaterial. The closer the investor’s voting securities holdings are to 10 percent of the banking organization, the more comfortable the Board may be with slightly larger business relationships.
The Board will also take a close look at any covenants that are part of an investor’s agreement with a banking organization. Any covenants that substantially limit the discretion of a banking organization’s management over major policies and decisions will likely hamper a request for a non-control determination. However, covenants that are limited to those that protect the rights of a particular class of security holder, such as limiting the issuance of additional amounts or classes of senior or those providing limited information and consultation rights, would generally be consistent with a non-control determination.
Change in Bank Control Act Notice Requirements
In many instances, the case-by-case review process and entry into commitments will occur through the filing of prior notice under the Change in Bank Control Act (“CIBCA”). 3/ The Policy Statement is an interpretation of the definition of control under the BHC Act and generally will not change the rebuttable presumptions of control and prior notice requirements under the CIBCA. Under the Federal Reserve’s CIBCA regulations, any person who owns, controls or holds with the power to vote 10 percent or more of any class of voting securities is presumed to control the banking organization if no other person controls a greater percentage of that class of voting securities, or the banking organization has registered securities under section 12 of the Securities Exchange Act. 4/ The CIBCA generally requires 60-days’ prior notice to the banking organization’s primary federal banking regulator before a person may acquire control. Therefore, investments of 10% or more will, in most cases, still require regulatory notice beforehand.
Previous news reports about the Fed’s efforts to revisit its policies on non-controlling equity investments may have heightened expectations that the review and revision would open the floodgates of private equity capital into a number of banking organizations. 5/ Though some observers may have hoped for greater flexibility in making non-controlling private equity or minority investments in banks or bank holding companies, the Policy Statement is in many ways a significant step in the evolution of the Board’s interpretation of the controlling influence prong of the definition of control. The changes adopted in the Policy Statement will make it easier for many private equity and other investors to invest in banking organizations. Moreover the Policy Statement should expand many banking organizations’ access to much needed capital.