The Fed Eases Restrictions On Private Equity Investments In Banks

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In the flurry of efforts to stem the global financial crisis, one move by the Federal Reserve Board may have been somewhat overlooked: in a statement issued September 22, 2008 (the "Policy Statement"), the Fed loosened long-standing policies to make it easier for private equity funds and other investors to acquire minority stakes in banks and other financial institutions. The Fed's new policy increases limits on overall equity holdings, permits director representation and relaxes certain restrictions on dealings with management, among other things. These changes could make banks and their parent companies more attractive investment targets for private equity.

The primary obstacle to private equity investments in financial institutions has been the risk that the investor will be deemed a "bank holding company" under the Bank Holding Company Act ("BHC Act"). Bank holding companies are subject to regulation and supervision by the Federal Reserve Board. There are strict limits on a bank holding company's nonfinancial activities and investments that would preclude the kind of diversification most private equity funds seek. Bank holding companies may be called upon to serve as a "source of strength" for their subsidiary banks, creating financial exposure for the investor beyond its equity investment.

The BHC Act provides that a company controls a bank,¹ and is therefore a bank holding company if (i) it owns or controls 25% or more of the shares in any class of the bank's voting stock,² (ii) it controls the election of a majority of the bank's directors or (iii) the Federal Reserve Board determines that the company otherwise controls the bank's management or policies.³ These statutory requirements have not changed. What has changed is the Fed's interpretation of the third prong in the control test: the Policy Statement addresses the factors that might cause an investor who holds less than 25% of a bank's voting shares and does not control the bank's board to be deemed a bank holding company and therefore subject to regulation and supervision.

Under the new policy, with the Fed's prior approval,⁴ an investor may acquire a minority interest in a bank without becoming a bank holding company, on the following terms:

• The investor may hold up to 15% of the bank's voting securities and up to 32.9% of the bank's total (voting and nonvoting) equity. Under prior interpretations, an investor was presumed to control a bank if it held 10% of the voting stock and total holdings were capped at 25%. An investment in more than 15% but less than 25% of a bank's voting stock will not necessarily make the investor a bank holding company, but it may be difficult to overcome the presumption of control at that level.

• For purposes of the limits on equity holdings, nonvoting shares are counted as voting stock if they may be converted at the option of the holder or if they mandatorily convert to voting stock on a future date. However, convertible shares do not count toward the limit on voting stock if they are only convertible upon transfer (i) to an affiliate of the investor or the bank, (ii) in a widespread public distribution, (iii) in transfers in which no transferee would receive 2% or more of the bank's voting stock or (iv) to a transferee that already controls more than 50% of the bank's voting stock.

• An investor may have at least one and up to two representatives on the bank's board of directors, if the representation is proportional to the investor's total equity holdings and does not exceed 25% of the board membership.⁵ However, a representative of a minority investor may not serve as chairman of the board or of any board committee. Under prior interpretations, no director representation was permitted.

• An investor may communicate with management about, and advocate for changes in, bank policy and operations, provided that the investor does not threaten to dispose of its shares or to initiate a proxy solicitation to force management action. The investor's participation must be limited to exercising voting rights as a shareholder or director. Under prior Fed guidelines, minority investors were generally required to commit not to attempt to influence bank operations and management.

• An investor may have a limited number of nonmaterial business relationships with the bank. The Fed will, however, continue to closely scrutinize such relationships so that they do not become a method of controlling bank management. ?

• An investor cannot impose contractual obligations on the bank that have the same effect as a controlling ownership interest (e.g., covenants that restrict the bank's ability to hire, fire or set compensation for executives, enter new lines of business, raise capital, undertake mergers or make other structural changes). An investor can, however, have limited veto rights over such matters as limitations on the bank's ability to issue senior debt or senior securities.

While the financial services industry continues to evolve rapidly (for example, as this article was being written, the Treasury Department announced plans for direct government investment in major financial institutions), the new policy will have benefits for private equity firms that want to acquire stakes in banks or bank holding companies. Perhaps more importantly, though, the new policy may help to introduce much-needed capital to the banking sector.

Footnotes

^{1. In this context, the term "bank" means nearly any FDIC-insured depositary institution, whether it is called a bank, savings & loan, industrial loan company or something else.}

^{2. Shares held by an investor's affiliates, its shareholders and their immediate family members may also count for purposes of this threshold.}

^{3. 12 U.S.C. § 1841(a)(2).}

^{4. Prior approval of the Federal Reserve Board is required for any acquisition that results in an investor holding more than 5% of a bank's voting shares; below 5% no approval is required and the investor is presumed not to control the bank.}

^{5. For example, an investor holding 15% of a bank's voting stock and 30% of the bank's total equity could have two representatives on an 8-person board but only one representative on a 7-person board.}

This article originally appeared in Dorsey's Private Equity Newsletter. Complete newsletter can be viewed at PDF download above.

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