In September the Board of Governors of the Federal Reserve System (the "Fed") released its Policy Statement on Equity Investments in Banks and Bank Holding Companies (the "Policy Statement"). The Policy Statement essentially modifies and clarifies certain positions previously articulated by the Fed and relaxes some of the important barriers that have discouraged private equity and other investors from purchasing minority stakes in banks and bank holding companies.
Given the current global banking crisis, the Fed has recognized the need for more capital in the banking sector and is looking to private equity as a potential source. While these barriers have not been completely removed, the Policy Statement marks an evolution in banking regulation that attempts to provide liquidity in the capital markets by encouraging investment in the banking sector.
Previously under the Bank Holding Company Act of 1956 (the "BHC Act"), any entity directly or indirectly acquiring more than 24.99 percent of a class of voting securities of a banking organization was considered to be in control of that banking organization and therefore deemed to be a bank holding company. For minority investors making acquisitions of 10 percent to 24.99 percent of a class of voting securities of a banking organization, a rebuttable presumption of control was created that may also result in such a determination. An investment of 9.99 percent or less does not create a presumption of control, rebuttable or otherwise.
Entities determined to be bank holding companies for purposes of the BHC Act are subject to regulatory oversight by the Fed, limitations on fund leverage, and, with limited exceptions, prohibitions on the ownership of non-banking assets and securities. To avoid the determination of control, the Fed usually required (i) the dispersion of ownership among equity holders; (ii) the execution of passivity agreements; (iii) the use of non-voting and other convertible securities; and/or (iv) the use of voting trusts headed by independent trustees.
In the Policy Statement, the Fed liberalizes it previous positions on control determination specifically in the areas of director representation, total equity ownership, consultations with management, and other indicia of control. These previous positions had been barriers to private equity investments in the banking industry.
The Fed generally has not permitted board representation by an investor holding between 10 percent and 24.99 percent of the voting stock of a banking organization. However, under the Policy Statement, where the investor owns less than 15 percent of the voting stock and another person owns a larger block of voting stock, the Fed permits a single board seat. The Fed also now recognizes that a minority investor with up to two board representatives, absent other indicia of control, is unlikely to control the institution where (i) the investor’s aggregate director representation is proportionate to its total equity interest, not exceeding 25 percent of the voting members of the board, and (ii) another investor is a bank holding company that controls the institution. The Policy Statement reiterates the Fed’s position that the representative of a minority investor should not serve as chairman of the board or any committee, and should not occupy more than 25 percent of the seats on any committee.
According to the Fed, an investor holding a very large equity stake is likely to have a controlling influence, even absent voting control. The Policy Statement reflects the continued belief that, in most circumstances, an investor holding 25 percent or more of the total equity of an institution owns enough to exert control over management or policies. Nonetheless, the Policy Statement also recognizes that the ability to exercise control through nonvoting equity investments depends on the nature and extent of the overall investment and on the capital structure of the institution. Therefore, under the Policy Statement, a minority investor is deemed to not have a controlling influence if the investor (i) owns a combination of voting and nonvoting shares that in the aggregate represent less than one-third of the total equity of the institution, and less than one-third of any class of voting shares upon conversion of all convertible nonvoting shares held by the investor, and (ii) does not own, hold or vote 15 percent or more of any class of voting securities.
Consultations with Management
In the past, the Fed typically required a significant minority investor with an ownership stake that gives rise to a rebuttable presumption of control to sign passivity agreements that limited the minority investor’s influence over the management, loan, credit or investment decisions of the banking organization. The Policy Statement provides additional guidance on the substance of communications between a minority investor and the management that would be consistent with a noncontrol determination. Generally, a noncontrolling minority investor may communicate with management about, and advocate changes in, the bank’s policies and operations, but only if such communication is not an attempt to exert a controlling influence.
Other Indicia of Control
Traditionally, the Fed has prohibited noncontrolling minority investors from having any material business relationships with a banking organization. However, the Policy Statement recognizes that not all material business relationships provide the investor with a controlling interest over management or policies, and therefore will continue to review business relationships on a case by case basis.