The Board of Governors of the Federal Reserve System ("Fed") on September 22 issued a much-anticipated policy statement providing some significant liberalizations of the agency’s position on minority equity investments in banks and bank holding companies that do not constitute "control" for purposes of the Bank Holding Company Act ("BHC Act"). Although the policy statement is not limited to private equity investments in banking organizations, its liberalizations clearly represent an effort by the Fed to address the concerns of private equity firms and other potential minority investors that the agency's rules have been inconsistent with prudent investment practices for minority investors. The policy statement is an initiative by the Fed to promote access by banks and bank holding companies that have suffered substantial losses in the current financial crisis to infusions of fresh capital from private investors.
Minority equity investments in banks and bank holding companies are typically structured to avoid triggering the definition of "control" in the BHC Act, which if triggered would cause the investor to become regulated by the Fed as a bank holding company, and as such to be subject to the Act's prohibitions on non-banking activities and investments. The statute provides that an investor has control over a bank or bank holding company if (i) the investor directly or indirectly owns, controls, or has power to vote 25 percent or more of any class of voting securities, (ii) the investor controls in any manner the election of a majority of the directors or trustees or (iii) the Fed determines, after notice and opportunity for hearing, that the investor directly or indirectly exercises a controlling influence over management or policies. Due to this definition, minority investments in banking organizations typically range from 10 to 24.9 percent of voting stock.
In order for a would-be minority investor to avoid triggering the "controlling influence" prong of the control definition, the Fed has typically required the investor to agree to "passivity commitments" relating to its investment and to avoid certain control-enhancing mechanisms. Investors have been required to limit the size of their voting and total equity investment, avoid covenants restricting the discretion of the banking organization's management as to major policies and operations, commit not to attempt to influence the banking organization’s process for making decisions about major policies and operations, limit director and officer interlocks with the banking organization, and limit business relationships with the banking organization.
Although the policy statement does not constitute a radical departure from the Fed's historical policies on "controlling influence," it significantly liberalizes three areas that have deterred some would-be investors from making banking investments:
- Board representation. Under the policy statement, a minority investor will now be generally permitted to have one representative on the board of a banking organization without being deemed to have a controlling influence over the latter's management or policies. Also, where the banking organization is controlled by a bank holding company, a minority investor may (absent other indicia of control) have up to two board representatives, provided the investor’s aggregate board representation is proportionate to its total interest in the banking organization and does not exceed 25 percent of the voting members of the board. Prior to these changes, the Fed had only permitted a minority investor to have a board representative if it owned less than 15 percent of the voting stock of the banking organization and another party owned a larger block of voting stock.
- Total equity. The Fed reiterated its traditional view that an investor that owns 25 percent or more of the total equity of a banking organization (i.e., both voting and non-voting) would in most circumstances have a controlling influence over that organization. However, the policy statement increases that threshold to one-third of total equity (and one-third of any class of voting securities, assuming conversion of any convertible non-voting securities), in situations where the investor does not own, hold or vote 15 percent or more of any class of voting securities.
- Consultations with management. The Fed's passivity commitments have typically required minority investors to agree not to attempt to influence the operations, management or strategies of the banking organization. The policy statement now provides that a non-controlling minority investor, like any other shareholder, may communicate with banking organization management about, and advocate for changes in, any of the organization's policies and operations, although such communications cannot be accompanied by explicit or implicit threats to dispose of shares in the banking organization or to sponsor a proxy solicitation.
As for the other indicia of control, the policy statement reiterates that business relationships between the minority investor and the banking organization should remain limited and will be reviewed by the Fed on a case-by-case basis. The policy statement makes no changes in the Board’s traditional policies regarding investment covenants. The policy statement provides that the principles outlined therein will also be applied by the Fed in analyzing investments by bank holding companies in non-banking firms.
The Fed's policy statement is available here (PDF).