Prospective investors considering minority stakes of more than five percent in banks or bank holding companies received a modest boost on September 22 when the Federal Reserve Board relaxed certain restrictions on non-controlling investments. The newly announced Policy Statement1 now permits, in very broad terms, an investor to acquire up to 33 percent of the total equity of a banking organization and to designate at least one director, without triggering the various regulatory requirements associated with control.2 The Federal Reserve also eased existing limits on consultations with management, business relationships and contractual covenants.
The Policy Statement may have several interesting consequences, many relating to the ability of minority investors to become more vocal. Voting representation on a board, together with the continued possibility of non-voting representation, will give minority stockholders more opportunity to voice concerns or displeasure with the management or decisions of a banking organization.3 The Policy Statement’s treatment of communications with management also suggests that these discussions are acceptable.
Potential investors should bear in mind that the Policy Statement is not the sole governing document for determining or avoiding control. The Policy Statement explicitly does not address action in concert, for example. Several investors contemplating a simultaneous investment in a banking organization will need to consider whether their joint action would cause them to be treated as a group. If so, their individual holdings would be aggregated in applying the control rules.
Background to Minority Investment Limits
Section 2(a)(2) of the Bank Holding Company Act provides that a person “controls” a banking organization if any of three criteria are met: (i) ownership or control of 25 percent or more of any class of voting securities; (ii) control over the election of a majority of the directors or trustees; or (iii) a determination by the Federal Reserve that the investor exercises (directly or indirectly) a “controlling influence” over the organization. The first two criteria are self-evident.
Application of the third standard, however, has yielded a substantial body of law, encompassing a policy statement in 19824 and two seminal letters in 1985 and 1992 that specified commitments to be made by investors to the Federal Reserve to ensure non-control,5 as well as several other interpretations. These commitments, known either as the CrownX or Liberty National commitments, are revised in important respects by the Policy Statement.
The Policy Statement outlines five sets of factors the Federal Reserve will consider in making a determination as to control: (i) equity ownership; (ii) director positions; (iii) business relationships; (iv) consultations with management; and (v) investment covenants.
Stock Ownership. A non-controlling investor may hold up to one-third of the total equity of a banking organization — provided that the investor holds less than 15 percent of any class of the organization’s voting securities. Arithmetically, then, for a minority investor that maximizes its permissible non-controlling economic interest, a majority of that interest must consist of non-voting shares.
Favorable treatment is now also available for convertible non-voting interests that have certain venture capital characteristics. Historically, the Federal Reserve has deemed all convertible shares to be voting shares for the purpose of the 25 percent voting securities test. This principle continues to apply to nonvoting equity investments with rights of conversion into voting shares at the election of the holder or that mandatorily convert after the passage of time.
Under the new policy statement, however, other convertible non-voting shares may not be treated as voting shares if the conversion right does not extend to the investor and if there is no mandatory conversion. Specifically, the Federal Reserve will not treat as voting any non-voting shares if the investor does not have the legal right to convert the shares and if the investor may transfer the shares only (i) to an affiliate of the investor or the banking organization; (ii) in a widespread public distribution; (iii) in transfers in which no transferee would receive two percent or more of any class of voting security; or (iv) to a transferee that would control more than 50 percent of the securities without the transfer.
Director Positions. The Policy Statement includes four rules about board seats for non-controlling investors. Non-voting representatives on the board remain permissible as well.
- One board seat is permissible for any minority investor. Previously, voting representation on the board was not available to any investor with 10 percent or more of a class of voting securities.6
- Two board seats are permissible under three conditions, the third of which precludes any second director at the top-tier holding company. First, the investor’s representation must be “proportional to total interests” in the organization. Second, the investor’s designated directors cannot constitute more than 25 percent of the board. Third, there is another controlling shareholder that is registered as a bank holding company.
- director designated by the investor may not serve as the chairman of the board or as a chairman of any of the board committees.
- If a designated director sits on a board committee, he or she may not constitute more than 25 percent of the committee — i.e., there must be at least three other board members on that committee. Additionally, as a committee member, a designated director may not have either the legal authority or the practical ability, unilaterally, to make policy or to block the making of policy or other decisions that bind the board or management of the banking organization.
Business Relationships. The Policy Statement does not comprehensively bar business arrangements between non-controlling investors and banking organizations, but the Federal Reserve must approve any such relationships on a case-by-case basis. In order to qualify for review, it appears that, as a practical matter, the relationship must satisfy three prerequisites: (i) the contract is on market terms; (ii) the arrangement is non-exclusive; and (iii) the relationship is terminable by the banking organization without penalty.7 If all three conditions are met, the Federal Reserve then will consider whether the relationship is quantitatively limited and qualitatively nonmaterial, such that the investor is not able to exercise a controlling influence. Ownership amounts will come into play here: A relationship is more likely to receive approval where the investor’s ownership of voting securities is closer to 10 percent than to 25 percent.
Consultations with Management. The Policy Statement permits a non-controlling investor and its representatives to communicate with management about, and advocate with management for changes in, any of the banking organization’s policies and operations. These communications also may include advocacy by minority investors for changes in management and recommendations for new or alternative management. In doing so, however, the investor may not threaten to sell its shares or to embark on a proxy solicitation.
Covenants. With respect to covenants entered into by a minority investor and a banking organization in connection with a non-controlling investment, the Federal Reserve historically has opposed covenants that substantially limit the discretion of management over major policies and decisions.8 This policy continues to apply to several types of covenants and contractual terms that restrict or inhibit the banking organization’s ability to make decisions in several areas, but the Policy Statement clarifies that other kinds of covenants are acceptable. Still problematic are covenants that place restrictions on the banking organization’s ability to (i) hire, fire and compensate executive officers; (ii) engage in new business lines or substantial changes to operations; (iii) raise additional debt or equity capital; (iv) merge or consolidate; (v) sell, lease, transfer or dispose of material subsidiaries or major assets; or (vi) acquire significant assets or control of another firm.
Other covenants, however, are acceptable, including ones that give the investor essentially the same rights as those of a holder of nonvoting securities under section 2(q)(2) of Regulation Y.9 Examples include covenants that prohibit the banking organization from issuing senior securities or borrowing on a senior basis, modifying the terms of the security or liquidating the banking organization, and those covenants that provide the investor with limited financial information rights and limited consultation rights.
A Few Observations
While the Policy Statement is not a dramatic departure from the Federal Reserve’s longstanding approach to controlling and non-controlling investments — nor could it be, given the statutory requirements that remain in place — there are some possible consequences or features that both banking organizations and potential investors should bear in mind.
First, the Policy Statement gives greater latitude to minority investors to make their views known about management and operations in a banking organization than these investors previously had. Banking organizations hoping to attract additional minority investors should be aware that these investors may be somewhat more vocal and active than previously would have been the case.
Second, while the Policy Statement focuses on how investments in banking organizations may steer clear of Section 3 of the BHC Act, the Policy Statement will affect investment decisions by bank holding companies under Section 4 of the BHC Act as well. Footnote 4 of the Policy Statement observes that the Federal Reserve will apply the same principles of “controlling influence” in analyzing investment by banking holding companies in non-banking firms. As a result, bank holding companies should have a somewhat greater ability to make investments without triggering application, notice or other regulatory requirements.
Third, for at least the past 25 years, minority investors with more than a five percent stake in a banking organization have sought written comfort from the Federal Reserve that they would not be deemed controlling shareholders. As part of this process, the Federal Reserve required various non-control commitments. The Policy Statement will modify these commitments, at least for minority investments in the future, but it does not purport to replace the practice of obtaining Federal Reserve clearance for a non-controlling investment. Accordingly, until there is greater clarification on this point, minority investors should still plan to seek the approval or non-objection of the Federal Reserve and should be prepared to make commitments that are still required under the Policy Statement.
Finally, the Policy Statement’s interpretation of “controlling influence” brings the Federal Reserve much closer to the control rules for investments in thrift institutions that the Office of Thrift Supervision has had in place for several years. The new guidelines for non-controlling investments in banking organizations will look more familiar to investors that may be accustomed to non-controlling investments in thrift institutions.