Monday afternoon (September 22) the Federal Reserve Board released a long-awaited "Policy Statement on Equity Investments in Banks and Bank Holding Companies," clarifying and to some degree liberalizing its policies permitting private equity funds, sovereign wealth funds, foreign banking organizations and similar entities (Non-BHC Investors) to make sizable but noncontrolling investments in US banks, bank holding companies and financial holding companies (banking organizations). For more than 50 years controlling investments in US banking organizations have been limited primarily to bank and financial holding companies (BHCs) approved and regulated by the Federal Reserve and limited by law and regulation to the business of owning and managing banking organizations.

While the Federal Reserve action does not involve any changes to the governing statute, the Bank Holding Company Act, or to its implementing federal administrative regulation, Federal Reserve Board Regulation Y, the new policy statement identifies ways in which Non-BHC Investors can involve themselves more closely with banking organizations in the areas of board seats, voting and nonvoting shareholding, consultation and communication with management, and business relationships. The main changes in these areas are summarized below.

(1) BOARD OF DIRECTOR REPRESENTATION. In the absence of other indicia of control, a Non-BHC Investor may have one board seat whether or not the banking organization in question has another shareholder that holds a greater percentage of voting shares. Subject to the same caveat, a Non-BHC Investor may have two board seats if (a) those two seats are proportional to its total interest in the investee, (b) those two seats do not exceed 25 percent of total board seats and (c) another shareholder is a BHC that controls the investee under applicable Federal Reserve rules. Directors placed in such seats by Non-BHC Investors may not serve as chair of the board or of any committee, but may serve as members of board committees so long as directors nominated by a particular Non-BHC Investor are not more than 25 percent of the members of any single committee and do not have any unilateral veto power.

(2) TOTAL EQUITY INVESTMENT. As a partial liberalization of its traditional 25 percent threshold, the policy statement provides that the Federal Reserve would not expect that a Non-BHC Investor would exert a controlling influence over a banking organization if the investor held a combination of voting and nonvoting shares that, when aggregated, amounted to less than 33-1/3 percent of the total equity of the investee so long as such holdings did not include more than 15 percent of any class of voting securities and did not include conversion rights which, if exercised, would allow the Non-BHC Investor's holdings to exceed 33-1/3 percent of any one class of voting securities.

With respect to nonvoting shares convertible into voting shares, the Federal Reserve restated its existing practice of counting such shares as voting shares if they are convertible at the election of the shareholder or automatically convertible after the passage of time. Significantly, however, the Federal Reserve reminded investors that in previous cases it had not counted convertible shares as voting shares if the conversion rights could only be exercised by certain classes of transferees of the original investor, including buyers in a widespread public offering or buyers of less than two percent in a placement. This feature would presumably allow Non-BHC Investors to make large immediate investments into large troubled US banking organizations and to recoup a portion of that investment through the later sale of the convertible securities to other investors.

(3) CONSULTATION WITH MANAGEMENT. The Federal Reserve frequently obtains so-called "passivity commitments" from Non-BHC Investors to help it make determinations that large investments by these investors do not entail control. Among these commitments are ones limiting the extent of communication between a minority investor and senior management of the investee banking organization. The new policy statement gives examples of communication modes consistent with a noncontrol determination, including communications involving dividend policy, capital planning, new business lines, mergers and acquisitions, and changes in senior management personnel. However, the policy statement stresses that, while such matters may be the subject of communication, they may not be accompanied by explicit or implicit threats to dispose of shares or sponsor a proxy solicitation or be made the subject of covenants in investment agreements.

(4) BUSINESS RELATIONSHIPS. The policy statement also liberalizes the Federal Reserve's traditional policy of prohibiting a noncontrolling minority investor from having any type of material business relationship with the investee banking organization. Subject to qualitative and quantitative parameters negotiated with the Federal Reserve, such business relationships should be increasingly permissible in the future.

(5) THE NEGOTIATION OF NONCONTROLLING RELATIONSHIPS WITH THE FEDERAL RESERVE. This new policy statement makes frequent reference to the Federal Reserve's 1982 "Policy Statement on Nonvoting Equity Investments by Bank Holding Companies." That 1982 statement, adopted to vet and control so-called stake-out investments as traditional rules against interstate banking were beginning to change, called for informal prior consultations with the Federal Reserve Board's legal staff in Washington before the execution of any investment agreement. Under this procedure the parties would normally agree upon a term sheet and draft agreements that incorporated those terms. However, before signing the agreements a determination would be obtained from the Board's legal staff that, in light of all facts and circumstances, the Non-BHC Investor would be a noncontrolling minority investor.

The policy statement issued Monday also contemplates that informal process. Over years of practice in this area Squire Sanders has had extensive experience in conducting these consultations, resulting in favorable noncontrol determinations in a series of sizable investments by Non-BHC Investor private equity funds and foreign banking organizations.