Partially in response to current market issues related to capital access for banking organizations, the Federal Reserve on September 22, 2008, released new guidelines which should help ease private equity investment in banking organizations without triggering the dreaded "bank holding company" restrictions and obligations that come with bank "control".

The expanded opportunities presented by the new guidelines should help banks secure investors that may otherwise shy away from bank equity investment due to the possibility of the investor becoming a de jure "bank holding company" as a result of the investment, and therefore subject to the business and activity restrictions of the Bank Holding Company Act ("BHCA"), the Fed's "source of strength" doctrine for forced contributions to bank subsidiary capital, and last but not least supervision and regulation by the Federal Reserve.

The guidelines provide more concise direction as to when minority capital (equity or debt) investment in the organization, coupled with other activities and involvement in the organization, will be considered to constitute "control" for BHCA purposes. As always, the Fed reserves the right to determine when, in their judgment, the totality of the relationship in any instance constitutes "control" for purposes of the BHCA. There remains, therefore, considerable risk in consideration of the overall relationship of the investor, or investors, with the institution and banks should take care to consult with legal counsel before entering into debt or equity (voting or non-voting) transactions with investors and/or lenders, granting board seats to investors, entering into business relationships with investors, or otherwise dealing with investors or potential investors in the organization. Mistakes in this area can have significant long-term unintended consequences for the institution and for the investor.

Interestingly, and importantly, investments by individuals are not subject to the BHCA unless they coincide with other "company" or related party investments, and are therefore not subject to the "control" concerns. To that end, individual investors may engage in equity investment in banking organizations without necessarily triggering the BHCA issues. As in every situation, however, care must be taken so as not to involve BHCA concerns through other relationships with that individual.

The following are the primary areas addressed by the new guidelines and the announced position of the Fed in these instances:

1. Board Seats 

The Fed has loosened its previous restrictions on board representation by minority investors (generally less than 24.9% of voting stock) to allow a minority investor to have one representative on the board without triggering the "control" determination. It is important to keep in mind, however, that if there are other indicia of "control" the Fed may still determine that the investor exercises a "controlling influence over the management or policies of the bank" sufficient to make a control determination. The expanded board representation policy relates only to that specific aspect of the relationship.

The guidelines also provide that up to two investor representatives may be allowed if the representation is (i) proportionate to the investor's total interest in the bank and (ii) does not exceed 25% of the voting members of the board, and (iii) another shareholder of the banking organization is a registered bank holding company that controls the bank under the BHCA.

The Fed believes that the minority investor representative(s) should not serve as board or committee chairs but may serve on committees so long as they do not occupy more than 25% of the seats on any committee.

Again, all of the foregoing is subject to other "indicia of control" that could result in a Fed control determination.

2. Controlling and Non-controlling Investments: Total Equity

Along with voting shares, the Fed looks at non-voting shares in its analysis of the degree of influence an investor may have in an organization and has historically taken the position that total equity (voting and non-voting) in excess of 25% generally raises "control" issues under the BHCA.

The new guidelines recognize the reality that there may be terms of non-voting equity that, when viewed in the totality of the circumstances surrounding the investor's participation in the organization and the overall capital structure of the organization, may not necessarily result in "control".

Therefore, the Fed has determined that (i) less than 1/3 of the total equity, (ii) less than 1/3 of the voting shares (including nonvoting convertible equity), and (iii) less than 15% of any class of voting securities, will not constitute "control" under the new guidelines.

Nonvoting shares that convert to voting shares at the election of the holder or over the passage of time will generally be treated as voting shares for purposes of control calculations. However, convertible nonvoting shares that have restricted transfer rights (to affiliates of the investor or bank; in a widespread public distribution; in transfers in which no transferee or group of transferees would receive 2% or more of any class of voting securities; or to a transferee that would control more than 50% of the voting securities of the bank without any transfer from the investor) may not be included in the control calculations.

Given the complexity of the guidelines with regard to equity participation, organizations should take care to review any proposed equity or debt issuances in detail with agency representatives prior to entering into a transaction that may trigger "control" concerns.

3. Influence Over Management

The Fed has historically required "passivity" commitments from minority investors that govern the ongoing interaction of the investor with the management and activities of the banking organization. In general, those commitments required the minority investor to treat the investment as a truly "passive" investment in terms of their interaction with the operations and management of the organization.

The new guidelines indicate that activities by the noncontrolling minority investor that consist of appropriate "lobbying" of bank management officials (directly or through their board representatives) with regard to certain policies and operations such as dividend policies, debt and equity strategies, lines of business, M&A strategies, and management changes, are not by themselves the type of controlling influence sought to be governed by the BHCA.

However, the Fed cautions that in all cases, the ultimate decisions on whether or not to adopt a particular position or take a particular action must remain with the board, management, or shareholders as a whole, as appropriate. The role of minority investors must be limited to (i) voting its shares as appropriate in matters subject to shareholder determination, and/or (ii) voting as board members. The Fed also cautions that communications by minority investors should not be accompanied by explicit or implicit threats to dispose of shares or to sponsor a proxy solicitation as a condition of action or non-action by the bank or its management.

This is an area that is ripe for conflict and may present issues and restrictions that are not consistent with general state laws governing rights and permissible activities of corporate shareholders. While the guidelines are helpful, there remains significant potential for subjective analysis by the Fed with regard to direct and indirect shareholder activity and care must be taken to avoid inadvertently triggering "control" concerns in engaging with bank management, the board, and other bank shareholders.

4. Other Indicia of "Control"

The guidelines also provide direction as to other situations and relationships that may trigger "control" issues under the BHCA:

  • Business Relationships: The Fed continues to examine those instances when material business relationships between a minority investor and the organization may result in "control" through the influence on the organization. The Fed will continue to review and analyze those relationships on a case-by-case basis.
  • Debt and Equity Covenants: Covenants in nonvoting securities (including debt) that substantially limit the discretion of bank management over major policies and decisions will be treated by the Fed as suggesting "control". Covenants protecting the financial investment and relating to issuing senior securities or borrowing on a senior basis, modifying the investor's security, or liquidating the bank would not, by themselves, be deemed to constitute "control".

Conclusion

While the new guidelines are very helpful and will hopefully result in further access to capital for banking organizations, the process remains extremely complicated and filled with traps for the unwary. Inadvertently triggering "control" under the BHCA can have serious consequences for the organization and for the investor, and whether a minority investor has a "controlling influence over the management or policies" of the banking organization remains a somewhat subjective issue, and is dependent on all the facts and circumstances surrounding the investor's investment in, and relationship with, the banking organization.

And that determination is subject to Federal Reserve subjective judgment to a certain degree, and is a fact-based analysis viewed with 20-20 hindsight. Relationships with minority investors can slowly and unintentionally be subject to "mission creep", as involvement with the organization increases without consciously attempting to exert "control".

Careful analysis ahead of time, combined with ongoing conscious awareness and sensitivity to the overall relationship in light of restrictions contained in the BHCA, should help banking organizations and investors avoid inadvertently becoming subject to the "control" burdens contained in the BHCA.