The Federal Reserve Board has approved regulatory revisions that expand the definition of “small bank holding company” and clarify the treatment of subordinated debt associated with trust preferred securities issuances. The revised rules raise the asset threshold that bank holding companies (“BHCs”) must meet to qualify for treatment under the Federal Reserve’s Small Bank Holding Company Policy Statement (“Policy Statement”) from less than $150 million to less than $500 million. Also under the revised rules, any subordinated debt associated with trust preferred securities that are issued by qualifying small BHCs will, for most purposes under the Policy Statement, be considered as debt. Under the previous rule, such subordinated debt associated with trust preferred securities was not considered as debt.

These new revisions will likely affect the majority of BHCs. According to the Federal Reserve, under the new rules, as many as 85% of BHCs may qualify for treatment under the Policy Statement. Qualifying for treatment as a small BHC has its advantages. For instance, a BHC that qualifies as a small BHC under the Policy Statement is subject to the Federal Reserve’s capital guidelines at the bank level only, rather than on a consolidated basis. Additionally, qualifying small BHCs, as compared to larger BHCs, are allowed to use a higher amount of debt to fi nance acquisitions.

All BHCs must comply with the Federal Reserve riskbased leverage capital guidelines (“Capital Guidelines”) unless they qualify as small BHCs under the Policy Statement. As previously noted, qualifying small BHCs are subject to more limited capital requirements and are allowed to operate with a higher level of debt than larger BHCs.

Traditionally, the Federal Reserve has discouraged the use of debt by BHCs to fi nance acquisitions because it believes that high levels of debt at the BHC level can impair the BHC’s ability to serve as a source of strength for its subsidiary banks. Recognizing that small BHCs typically do not have access to the same funding facilities as large BHCs when engaging in acquisitions, in 1980, the Federal Reserve issued the Policy Statement, which loosened the debt restrictions for small BHCs. By explicitly permitting the formation and expansion of small BHCs with debt levels that are higher than would typically be permitted for larger BHCs, the Policy Statement helped facilitate the transfer of ownership of small community banks in a manner that is consistent with safety and soundness.

Prior to the recent revisions, the Policy Statement provided that BHCs with pro forma consolidated assets of less than $150 million, that were not engaged in any non-banking activities involving signifi cant leverage, were not engaged in signifi cant off balance sheet activities, and did not have a signifi cant amount of outstanding debt being held by the general public, would qualify for treatment as a small BHC under the Policy Statement. Such qualifying small BHCs were eligible to use debt to finance up to 75% of the purchase price of an acquisition. The small BHCs, however were subject to a number of ongoing requirements. For example, one of the principal requirements was that the small BHC must reduce its parent company’s debt in such a manner that all debt is retired within 25 years of being incurred.

Moreover, under the previous version of the Policy Statement, subordinated debt on the parent company’s balance sheet that was issued in connection with trust preferred securities was not treated as debt. The cashflow impact, however, of such subordinated debt was included in the Federal Reserve’s review of the financial condition of the BHC.

New Asset Threshold

The revisions to the Policy Statement raise the asset threshold for qualification under the Policy statement from less than $150 million to less than $500 million. Under the revised guidelines, BHCs with consolidated assets of less than $500 may qualify, subject to qualitative requirements, for the relaxed capital requirements of the Policy Statement. By raising the asset threshold to $500 million, the Federal Reserve estimates that approximately 85% of all BHCs may qualify for treatment under the Policy Statement. This is a substantial increase from the 55% of BHCs that were previously eligible to qualify under the $150 million asset threshold.

Changes in Qualitative Criteria

In addition to raising the asset threshold for eligibility under the Policy Statement, the Federal Reserve also modified the qualitative criteria for determining eligibility. Not only must a BHC meet the new “less than $500 million” quantitative threshold to qualify for treatment under the Policy Statement, a BHC must also meet the following qualitative criteria:

1. The small BHC must not be engaged in significant nonbanking activities, either directly or through an non-bank subsidiary;

2. The BHC must not conduct significant off balance sheet activities, including securitizations or managing or administering assets for third parties, either directly or through a non-bank subsidiary; and

3. The BHC must not have a material amount of debt or equity securities (other than trust preferred securities) outstanding that are registered with the Securities and Exchange Commission (“SEC”).

What constitutes a “significant” amount of nonbanking activities or a “material” amount of SECregistered debt or equity will depend on the size, activities and condition of a particular BHC.

According to the Federal Reserve, these changes to the qualitative criteria reflect the changes to the banking industry over the last two decades, including the nature of the operations of many of the smaller BHCs. For example, following the enactment of the Gramm-Leach-Bliley Act in 1999, banks were allowed to expand the range of non-banking activities in which they could engage. The Federal Reserve believes that significant involvement in these expanded non-banking activities may result in a higher level of operations, legal and reputational risk to the overall banking organization and, as a result, BHCs taking part in significant non-banking activities should not be covered by the Policy Statement.

Unlike the previous version of the Policy Statement, the revised criteria excludes any BHC that has a material amount of SEC-registered debt or equity securities outstanding. The Federal Reserve believes that when BHCs have a material amount of SEC-registered securities, it is an indication that the BHCs exhibit a higher degree of complexity of operations and have access to multiple funding sources, which warrants excluding them from the Policy Statement.

Changes in Treatment of Trust Preferred Securities

The revisions to the Policy Statement provide that subordinated debt associated with trust preferred securities is treated, for most purposes under the Policy Statement, as debt. Under the previous version of the Policy Statement, subordinated debt on the parent company’s balance sheet that was issued in connection with trust preferred securities was not treated as debt. Specifi cally, under the new rule, subordinated debt associated with trust preferred securities is considered as debt in determining whether:

1. A qualifying small BHC’s acquisition debt is 75% or less of the purchase price; or

2. A qualifying small BHC’s debt-toequity ratio is greater than 1.0:1.

A qualifying BHC, however may exclude from debt an amount of subordinated debt associated with trust preferred securities equaling up to 25% of the small BHC’s stockholder’s equity, minus parent company goodwill.

Furthermore, subordinated debt associated with trust preferred securities is not considered as debt in determining compliance with the Policy Statement’s ongoing 12-year debt reduction and 25-year debt retirement requirements. Under these ongoing debt reduction and retirement requirements, small BHCs must reduce their parent company debt consistent with the requirement that all debt be retired within 25 years of being incurred. The Federal Reserve also expects small BHCs to reach a debt-to-equity ratio of .30:1 or less within 12 years of the incurrence of the debt.

To provide qualifying small BHCs with adequate time to conform their debt structures, the Federal Reserve has provided for a fi ve-year transition period. During this time, all subordinated debt associated with trust preferred securities issued prior to the date of the proposed rule (September 8, 2005) is not considered debt under the Policy Statement. This temporary non-debt status, however, terminates if the qualifying small BHC issues or has issued additional subordinated debt associated with a new issuance of trust preferred securities after the date of the proposed rule. For those trust preferred securities issuances that were pending on the date of the proposed rule, there is a five-year transition period, during which subordinated debt associated with the trust preferred securities issued on or prior to December 31, 2005 will not be considered debt under the Policy Statement. Qualifying small BHCs may also refi nance existing issuances of trust preferred securities without losing the exempt status of the related subordinated debt under the Policy Statement during the transition period, as long as the amount of subordinated debt does not increase.

Revisions to Regulatory Reporting

The Federal Reserve is also expected to issue a separate notice revising the regulatory reporting requirements for BHCs meeting the new definition of “small bank holding company.” Under these expected new revisions, qualifying BHCs would be required to submit parent-only fi nancial data on the form FR Y-9SP on a semi-annual basis. Currently, BHCs with assets of $150 million or more must fi le parent-only and consolidated fi nancial data on a quarterly basis.