In an unheralded Supervision and Regulation Letter (Letter) issued by the Board of Governors of the Federal Reserve System (Board) on December 3, 2015 (SR 15-15), the Board provided guidance to explain “Supervisory Concerns Related to Shareholder Protection Arrangements” established by bank and savings and loan holding companies. The Board made it clear that the Letter applies to all holding companies regardless of size and regardless of whether publically or privately held. The Letter appears to be in response to the Board’s increasing disaffection for these types of arrangements. A copy of SR 15-15 may be found here.
The Board is focused on arrangements that it believes are designed to benefit certain shareholders, enhance short-term investor returns, and/or provide a disincentive for investors to acquire or increase ownership in a holding company. Supervisory staff has determined that, in certain circumstances, these types of arrangements would have negative implications on a holding company’s capital or financial position and limit its financial flexibility and ability to raise capital. It is the Board’s position that arrangements such as these impede the holding company’s ability to serve as a source of strength to its subsidiary bank or thrift as required by Section 616(d) of the Dodd-Frank Act and the Board’s Regulations Y and LL and may be considered to be unsafe and unsound.
The Letter describes a non-comprehensive list of arrangements which have raised supervisory concerns including:
- Down Rounds---these can take many forms but are designed to protect existing shareholders in the event the holding company offers to sell stock in a capital raise or acquisition at a price less than that paid by existing shareholders.
- Poison Pills---these were developed as defensive mechanisms in connection with an unwanted acquisition offer for the holding company. There are multiple forms, but they are generally set up to increase the ownership of existing shareholders verses the buyer of a significant block of shares with the effect of diluting the buyer and thwarting the takeover offer.
- Restrictions on Transfer---these arrangements can include complete prohibition on share transfers, but-sell agreements, rights of first refusal, or other arrangements that restrict the transfer of shares
Interestingly, the arrangements described above have been in use for decades. The Board’s increased focus, in part, is the result of the enactment of Section 616(d) of the Dodd-Frank Act which requires a holding company to be a source of strength for and to stand ready to use its resources to provide capital to its subsidiary bank or thrift, especially during periods of financial stress.
If examinations or applications staff determine that a proposed or existing shareholder protective arrangement impairs the ability of a holding company to raise or maintain capital, the staff is directed to consult with Board supervisory staff. This review and consultation is to be done whether or not there is a formal application or other approval requirement. Simply put, the staff can initiate an objection to a shareholder protective provision independently.
Ironically, the Board’s position may actually foster short-termism, also known as quarterly capitalism, with respect to public holding companies and deter capital formation at private holding companies. It is noteworthy that on March 17, 2016, shortly after the Letter’s release, legislation was introduced in the U.S. Senate (The Brokaw Act) intended to strengthen oversight of “activist” investors. Increasingly “wolf packs” of investors will attempt to take control of a company or a acquire a sizable stake of its shares and demand short-term returns at the expense of the company’s long-term success or an outright sale of the company. Further, a closely held bank or thrift holding company, like any other closely held company, must respect the rights of its early investors as well as be mindful of who holds its shares. Absent some of these protective provisions, initial capital formation may be impeded and further consolidation of the industry is likely. The result will be a smaller number of larger institutions; not exactly what congress says it had in mind.
All boards and managements should be aware that the Board may object to a shareholder protection arrangement based on its perception of the facts and circumstances and the specific arrangement. The Board may direct a board of directors to modify or remove a shareholder protection arrangement that it believes gives rise to safety and soundness concerns. The Board’s position is not limited to holding companies with troubled bank or thrift subsidiaries. This action is likely even if the holding company and subsidiary bank or thrift are well capitalized and well managed. It is unclear how deep the drill down will go; what if a restriction on transfer provision is in an employment agreement between an executive and a private holding company?
The Board seems to have reversed years of neutrality in dissident shareholder disputes over corporate governance and placed itself in the uncomfortable middle as the arbiter of what is good for shareholders. One can expect activist investors to augment their tactics and seek the Board’s involvement in their campaigns to unseat directors, force a sale of the holding company, or other self-serving goals; conflating shareholder interests with what the Board believes will add strength to the holding company.
In light of the Board’s increasingly aggressive posture with respect to what it terms shareholder protection arrangements, boards and managements should consult with counsel before considering any arrangements of this nature. Moreover, they may want to have a review of current arrangements undertaken to evaluate what the company’s exposure is and whether the company is at risk of an adverse determination by examinations or applications staff.