Why it matters
Deals with favored investors have fallen out of favor with the Federal Reserve Board of Governors, as evidenced by a new memorandum from the regulator. SR 15-15, issued on December 3, 2015, cautions banks that certain arrangements may pose safety and soundness concerns necessitating the deals to be modified or eliminated. Five arrangements were highlighted by the Fed as problematic: a company agrees to make payments to an investor if later investors are allowed to buy shares at a lower price; a company agrees to provide an investor additional shares at little to no cost if later investors are allowed to buy shares at a lower price; investors are allowed to buy additional shares at below market prices if any shareholder's interest crosses a percentage threshold; investors who control a holding company but do not have a majority interest in the company have a right to prevent the company from issuing more shares or the ability to restrict the company's ability to do so; or the company's board of directors can nullify share purchases, require the company to buy shares back from a purchaser, or take other steps "that would inhibit secondary market transactions in the company's shares." According to the Board, these types of arrangements give an advantage to current shareholders and are intended to protect their investments—not protect the viability of the company.
Banks and savings and loan holding companies, take note: the Federal Reserve Board of Governors has released a new memorandum expressing concern about deals with favored investors.
"[S]uch arrangements raise concerns because they could have negative implications on a holding company's capital or financial position, or limit the holding company's ability to raise capital in the future," the Fed wrote in SR 15-15. "A holding company, regardless of its asset size, should be aware that the Federal Reserve may object to a shareholder protection arrangement based on the facts and circumstances and the features of the particular arrangement."
What types of arrangements is the Fed keeping an eye on? The memo listed five examples of deals, including "down round" provisions, where the holding company agrees to provide an investor with cash payments reflecting the difference between the price paid by the investor and a lower price per share paid by investors in subsequent transactions as well as situations where the holding company agrees to provide an investor with additional shares of stock for minimal or no additional cost in the event that the holding company issues shares at a price below the price paid by the investor.
Also objectionable: "poison pill" provisions, allowing existing shareholders of the holding company to acquire additional shares at significant discounts to market value in a new offering if any shareholder crosses a specific ownership threshold and clauses that grant investors with less-than-majority control the contractual right to restrict or prevent the holding company from issuing additional shares.
Finally, the Fed frowned upon the ability of a holding company's board of directors to nullify share purchases under certain circumstances, require the holding company to repurchase the shares of the company from a new owner of the shares, or take other actions that would significantly inhibit secondary market transactions in the shares of the holding company, such as complete prohibitions on share transfers or rights of first refusal.
"Arrangements of these types (in whatever form) have the potential to impose additional financial obligations on a holding company or restrict in some way the primary or secondary market for the holding company's shares," according to the Federal Reserve. "Often, these arrangements serve to protect the value of the initial investment made by a particular subset of shareholders rather than the viability of the issuing holding company, or, in other ways, provide current shareholders with an advantage over future, similarly situated, investors."
If the Fed determines that a particular shareholder protection arrangement impairs the ability of a holding company to raise or maintain capital—particularly during a period of stress on the firm—or that a provision is in violation of applicable supervisory enforcement action, the regulator said the Board will determine the appropriate action.
"The Federal Reserve may direct a holding company's board of directors to modify or remove a shareholder protection arrangement that gives rise to safety-and-soundness concerns," the Board warned. "The corrective actions, if any, will vary depending on the facts and circumstances of the holding company, as well as applicable state and federal laws and regulations, corporate charter and by-laws, and other considerations."
To read SR 15-15, click here.