Yesterday, September 23, 2008, the Federal Reserve Board (“Board”) released its Policy Statement on equity investments in banks and bank holding companies. The Board’s guidance is intended to focus on minority equity investments that would not rise to the level of “control” for purposes of the Bank Holding Company Act (the “Act”).
The Board’s Policy Statement gives examples of participation in a banking organization (as a minority equity investor) that would not constitute controlling influence over the banking organization. Each situation is based upon a facts-and-circumstances evaluation.
- Board of Directors Representation: The Board will now allow a minority investor to have a single representative on the board; the investor can even have up to two representatives so long as this does not exceed 25 percent of voting members and another shareholder is a controlling bank holding company. Such a representative cannot be chairman of the board nor chair of a committee, but can be a committee member.
- Total Equity: Generally, ownership by a minority investor of 25 percent or more of a banking organization’s total equity confers a controlling influence over its management or polices. However, if such an investor’s voting and nonvoting interests represent less than one-third of the equity and its voting interest is limited to less than 15 percent of a class of voting securities, the potential for exercising a controlling influence is reduced. Nonvoting interests are deemed voting if (i) they can be converted to voting at the election of the holder of the shares, or (ii) they mandatorily convert by the passage of time.
- Consultations with Management: A non-controlling minority investor may communicate on a general basis with the banking organization’s management about, and may advocate for changes in, any of the banking organization’s policy and operations, including changes in management. The communications, however, should not be accompanied by explicit or implicit threats to dispose of the banking organization's shares or to sponsor a proxy solicitation as a condition of action or non-action.
- Business Relationships: The Board has always been concerned with the business relationships that a non-controlling minority investor has with a banking organization, particularly if the investor is a major supplier, customer or lender. The Board continues to believe such relationships should be limited, and the Board will consider the size of the proposed business relationships, its market terms, whether non-exclusive and terminable without penalty by the banking organization.
- Covenants: Where an investment is structured as a nonvoting interest, an attempt is made to substitute a contractual agreement for rights that normally are obtained through ownership of voting securities. The Board’s position has been that contractual covenants that substantially limit the discretion of a banking organization’s management over major policies and decisions suggest the exercise of a controlling influence. Those kinds of covenants include decisions such as: hiring, firing and compensation of executive officers; engaging in new business lines; raising debt or equity capital; merging or consolidating entities; selling, leasing, transferring or disposing of material subsidiaries or major assets; or acquiring significant assets or control of a firm. However, covenants that give an investor rights permissible for a holder of nonvoting securities, such as the prohibition of a banking organization from issuing senior securities, modifying the terms of an investor’s security, or liquidating the banking organization, would not be considered sufficient to find controlling influence.
The Board has been notably mindful of two key purposes of the Act in assessing an investor’s ability to exercise a controlling influence over a banking organization. First, the Act was intended to tie control and responsibility together to ensure that companies that control banking organizations have the financial and managerial strength, integrity, and competence to exercise that control in a safe and sound manner. This principle ensures that companies have the necessary incentives to run a successful organization, but that they also bear the risks and costs of their involvement in the banking organization’s decision-making process. Second, the Act was intended to limit the mixing of banking and commerce. According to the Board’s Policy Statement, the Act effectively prevents commercial firms and companies with commercial interests from also exercising controlling influence over a banking organization. These principles are the basis of the Board’s evaluation of whether a minority equity investment would rise to the level of “control” for purposes of the Act.
In the current financial market, it is becoming increasingly likely that banking organizations will have to look to private equity, sovereign wealth funds and other concentrations of wealth, for capital. While the Board’s Policy Statement deals with the issue of minority equity investments that do not rise to a “control” level, the issue of investments by private equity funds and other investors is not addressed. These investments will raise concerns with the definitions under the Act of “control” and “acting in concert.” The Board will need to deal with these concerns and issue relevant guidance in the near future.