United States: Gramm-Leach-Bliley Act Of 1999

• Such affiliations are permitted only through the establishment of financial holding companies ("FHCs"), which are "bank holding companies" ("bhcs") that are subject to "umbrella" supervision by the Board of Governors of the Federal Reserve System (the "FRB").
• Insurance underwriters, agents, securities broker-dealers and investment advisors, and depository institutions are treated as "functionally regulated" subsidiaries of FHCs. The FRB is generally required to defer to the functional regulator for such subsidiaries.

Although the GLB Act preserves the role of the state insurance regulators and the National Association of Insurance Commissioners ("NAIC"), it creates regulatory and market pressures to establish a dual state and federal insurance regulatory framework.

• The GLB Act preempts state anti-affiliation statutes (and any other form of state regulation) that would restrict depository institutions from affiliating with an insurer.
• It provides that states cannot "prevent or significantly" interfere with the ability of a depository institution or its affiliates to engage, directly or indirectly, by itself or with others, in insurance sales, solicitations, or cross-marketing. The statute, however, creates a safe harbor for certain specified types of state insurance regulation.
• Each of the federal bank regulators now has proposed rules, as required by the GLB Act, that will govern sales of insurance products by depository institutions (including Internet sales).
• The GLB Act also freezes the types of insurance products national banks and their subsidiaries can underwrite as part of the business of banking as they were at the beginning of 1999 and, in effect, requires any new insurance products proposed to be underwritten by banks to be provided through the FHC. Although qualifying banks can acquire "financial subsidiaries" that engage in most activities permissible for FHCs, such subsidiaries cannot engage in insurance underwriting, real estate development or merchant banking.
• To facilitate the operation of multistate FHCs, the GLB Act requires a majority of the states to have in force by November 12, 2002 uniform or reciprocal insurance laws meeting specified minimum standards, or face the establishment of, in effect, a federally authorized self-regulatory organization with the power to impose such uniform standards.
• To facilitate the formation of FHCs by mutual insurers, the GLB Act enables them to redomesticate to a state whose laws are friendlier to mutual/stock conversions.
• The GLB Act and the federal agencies' regulations establish minimum federal standards that will govern customer privacy for all "financial institutions," including insurance companies and agents.

An insurer that wishes to acquire a commercial bank and become an FHC must first become a bhc by applying to the FRB under Section 3 of the BHC Act for permission to become a bhc and simultaneously filing a declaration with the FRB to be an FHC.

To qualify as an FHC, all "depository institutions" controlled by the bhc must be "well capitalized" and "well managed." Each "insured depository institution" must have at least a "satisfactory" Community Reinvestment Act ("CRA") rating. A foreign bank whose only U.S. banking presence is through ownership or control of one or more U.S. bank subsidiaries is treated like a domestic bhc for purposes of qualifying as an FHC. Foreign banks doing business in the U.S. through branches or agencies must also meet the "well capitalized" and "well managed" standards at the "parent" foreign bank, and not solely at the U.S. branch or agency. The "well capitalized" standard for foreign banks includes a requirement to maintain at least a three percent leverage capital ratio, although the FRB has retained flexibility in determining whether a foreign bank is "well capitalized." The CRA requirement extends to FDIC insured branches of foreign banks.

If a depository institution subsidiary of an FHC ceases to be "well capitalized" or "well managed," the FHC will be subject to restrictions on its activities and acquisitions as determined by the FRB. The FRB has substantial discretion in determining the consequences of an FHC's failure to meet the well capitalized or well managed standard.

• While the failure to meet the CRA standard will prevent a bhc from qualifying as an FHC, once it has so qualified, losing the "satisfactory" CRA rating will not cost the FHC its status as such, but will prevent the FHC from engaging in new "financial activities" or acquiring a company engaged in such activities, other than in merchant banking and insurance investments. The FRB has little, if any, authority to waive or modify penalties arising from the failure to meet CRA standards.

An insurer that affiliates with a commercial bank will continue to be regulated by its functional regulator—the state insurance department. However, it must also be prepared for the FRB's "umbrella" regulation of the entire FHC. Such regulation will involve annual examinations to assess the FHC's ability to manage credit, market, liquidity, operational, legal and reputational risks, across legal entity lines. FRB examiners will meet periodically with the FHC's senior management, and annually with the FHC's board of directors. There will also be extensive reporting requirements, including reports of intercompany transactions.

• Transactions between depository institution subsidiaries of FHCs and their cross-stream affiliates will be subject to Sections 23A and 23B of the Federal Reserve Act, which limit loans or other extensions of credit by a bank (or its subsidiaries) to not more than ten percent of its capital and surplus to any single affiliate, and to 20 percent of capital to all affiliates; require such extensions of credit to be collateralized up to 130 percent; and require that all such transactions be at arm's length. Because of complex attribution principles, these statutes apply to a variety of circumstances that are not readily apparent.

The GLB Act authorizes an FHC to engage in any activity, and acquire the shares of any company engaged in any activity, that is "financial in nature" or "incidental" to such financial activity, or that is determined to be "complementary" to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Virtually all activities currently permissible for bhcs domestically and abroad are permissible for FHCs.

• The FRB, in consultation with, or upon the recommendation of, the Treasury, can determine by regulation or order whether additional activities are "financial in nature," or are "incidental" to a financial activity. The FRB has proposed to add a variety of finder activities, relating to e-commerce, to the list of financial activities. The GLB Act also authorizes the FRB alone, without input from the Treasury, to determine whether an activity is "complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally."
• The GLB Act also allows FHCs to engage in certain "merchant banking" and "insurance company investment" activities. These exceptions were intended to enable insurance companies and securities firms to buy commercial banks, as well as to allow commercial banks to acquire insurers and securities firms, referred to as the "two-way street."
• The acquisition (or retention) of foreign banks by FHCs will continue to require the FRB's prior approval. Thus, insurance companies that apply to become an FHC and own foreign banks will be required to apply to the FRB to retain them.

The most significant provision of the GLB Act from the standpoint of establishing financial affiliations as a "two-way street" is the authority granted FHCs to engage in merchant banking ("Merchant Banking"). Merchant Banking generally refers to a company's investment of its own capital in equity interests of other companies (each a "Portfolio Company"), including controlling interests, with a view toward the ultimate sale of such interests at a profit.

• An FHC that wishes to conduct Merchant Banking activities must have within its corporate group either (1) a registered broker or dealer, or (2) an insurance company predominantly engaged in underwriting (i) life, accident and health insurance, (ii) property and casualty insurance (other than credit related insurance), or (iii) annuities, and a registered investment advisor that advises an insurer.
• No prior notice to the FRB is required to commence Merchant Banking activities; only a 30-calendar-day post-commencement notice is required. Written notice must also be provided to the FRB within 30 calendar days of consummation of a Merchant Banking investment that (i) comprises more than a five percent ownership interest in the Portfolio Company and (ii) costs more than five percent of the FHC's Tier 1 capital or $200 million, whichever is less.
• An FHC may control Portfolio Companies acquired under the Merchant Banking authority, but may not "routinely manage or operate such company or entity except as may be necessary or required to obtain a reasonable return on investment upon resale or disposition."
• Contractual requirements that would restrict a Portfolio Company's ability to make routine business decisions would also be prohibited. This includes agreements that restrict the hiring of employees below the five highest executive officers and covenants that restrict the Portfolio Company from entering into transactions in the ordinary course of business. An FHC can impose contractual requirements relating to extraordinary events, including acquisitions, significant changes in business plans, changes in capitalization and the sale, merger or liquidation of the Portfolio Company.
• The FRB allows intervention in day-to-day management only when necessary "to address a material risk to the value or operation of the Portfolio Company, such as a significant operating loss or loss of senior management," and only for such period of time as is necessary to address the problem, sell the investment, or otherwise obtain a reasonable return on resale or disposition of the investment, which cannot extend beyond six months without the FRB's prior approval.
• The FRB has set a fixed ten-year holding period for most Merchant Banking investments, which can be exceeded only with the FRB's approval and at substantial cost. Somewhat more relaxed holding periods are provided for qualifying private equity funds. Such funds may be retained, and may retain their investments, for the duration of the fund, which is for a maximum of 15 years. Investments held by a non-qualifying fund that is controlled by the FHC will be subject to the ten-year divestiture period.
• The aggregate carrying value of the Merchant Banking investments held by the FHC cannot exceed (1) the lesser of 30 percent of the FHC's Tier 1 capital and $6 billion, and (2) the lesser of 20 percent of the FHC's Tier 1 capital and $4 billion excluding interests in qualifying private equity funds, without the FRB's consent.
• The FRB has proposed a deduction of 50 percent of the carrying value of all Merchant Banking investments as well as any investments made by any bhc under its existing investment authorities, including investments through SBICs, bhc investment companies and offshore investments, from the top tier parent's Tier 1 capital. If a bhc owns or controls 15 percent or more of a company's total equity, the capital charge will also apply to all of the company's debt to the bhc and subsidiaries, with a few narrow exceptions.
• Records of Merchant Banking activities must be maintained centrally, regardless of where or in how many corporate or other vehicles an FHC conducts such activities. The level of reporting for a Merchant Banking investment ratchets up sharply when an FHC holds an investment for more than five years (eight years if held through a qualifying private equity fund).
• A depository institution controlled by an FHC, including U.S. branches and agencies of foreign banks that elect FHC status, may not cross-market any product or service of a Merchant Banking Portfolio Company.
• Private equity funds constitute a special class of Merchant Banking investments. They raise the issue of the application of the FRB's requirements not only with respect to investments by FHCs in private equity funds, but also with respect to the "look through" to the Portfolio Companies in which the private equity funds invest. The FRB has established a complex series of requirements that define a private equity fund that is entitled to limited types of regulatory relief. FHCs may also invest in other private equity funds, but without the regulatory relief afforded qualified funds.

An insurer that is considering the acquisition of a commercial bank has a much more difficult decision to make than a bhc's decision to acquire an insurer. Bhcs, as well as foreign banks that operate in the United States through branches or agencies, are subject to all of the restrictions of the BHC Act. Electing FHC status, if they can do so, affords substantial benefits in the scope of permissible activities and relief from burdensome approval procedures. In contrast, an insurance company that elects to affiliate with a bank in an FHC structure will for the first time be subject to the FRB's "umbrella" supervision, as well as to a legislative and regulatory structure that limits its activities in ways to which it is not accustomed.

Any insurer considering FHC status must make a full evaluation of all of its lines of business to ensure that they are permissible for an FHC. To the extent its (or its affiliates') activities do not fall within these categories, the insurer must decide whether the GLB Act's limited "grandfather" provisions apply and are sufficient and, if not, whether it is willing to cease the activity. For example, an insurer that owns and operates a health maintenance organization (HMO) must convince the FRB that this activity is incidental or complementary to a financial activity. Alternatively, it must determine whether the HMO is eligible for the GLB Act's 10-15 year grandfather, which bars expanding the business by acquisition, or whether to divest the HMO. Likewise, an insurer with a significant investment management or venture capital business must decide whether it can conduct this business consistent with the FRB's Merchant Banking rules and whether the GLB Act's insurance company investment authority is adequate for its business.

Foreign bancassurance companies will have the additional concern that they are not currently eligible to be treated as qualifying foreign banking organizations under the FRB's Regulation K, which means that their worldwide operations would be subject to the restrictions of the BHC Act. To the extent that they are engaged in non-financial activities both within and without the United States, this may significantly limit their willingness to become an FHC.

All insurers should consider whether it is necessary to formally affiliate with a commercial bank to achieve the market benefits of combining banking and insurance. A number of insurers have acquired thrift depositary institutions and are today grandfathered savings and loan holding companies. These institutions can offer their customers banking and trust products through an affiliated federal savings bank or other thrift depositary without the need to elect FHC status. Various cross-marketing arrangements have also grown substantially in recent years.

It is likely that in future years the FRB will ease the regulatory burdens associated with FHC status in much the same way as it liberalized the "firewalls" governing Section 20 companies over the past two decades. The FRB will first need to satisfy itself that activities such as Merchant Banking can be conducted by FHCs in a manner that is not harmful to their depository institution subsidiaries and without undue risk to the financial system. In the meantime, it is likely that insurers and securities firms that are not currently subject to FRB supervision will avoid initiating an affiliation under the provisions of the GLB Act except in connection with a major strategic acquisition or a strategic business effort. However, to the extent insurers' returns on assets and equity improve and bhcs' market capitalization sufficiently increases, the GLB Act ensures that we will witness a growing number of bank-insurer combinations.