September 30, 2008

FRB Publishes Guidance on Minority Investments in Banks

The FRB published guidance (the “Guidance”) on minority investments in banks and bank holding companies (“BHCs”). The Guidance can be used by private equity firms, sovereign wealth funds and other minority investors in banking institutions. The Guidance states that the FRB also will use the principles it articulated in the Guidance to analyze investments by BHCs in nonbanking firms. The Guidance largely clarifies the FRB’s position on certain issues, but also provides greater leniency in certain areas.

Historical Approaches. The Guidance provides historical background on the FRB’s reasoning, focusing particularly on the limitations on ownership, management direction by investors and share transfer set forth in the 1982 Policy Statement on Nonvoting Equity Investments by Bank Holding Companies. The Guidance also discusses the passivity commitments certain relatively large investors enter into to avoid a control determination.

Specific Approaches to Avoid Control. The Guidance then discusses specific approaches that minority investors can reference to avoid control.

Directors. Historically, the FRB generally has not allowed a minority investor with over 10 percent of the voting stock of a banking institution to also have a board member on the institution. Noting that bank boards generally have 9-10 members, the Guidance states that a single representative should not create a controlling influence. Moreover, the Guidance provides that even 2 representatives would be permissible provided that: (1) the representation is proportionate to the investor’s total interest (i.e., greater of voting interest or total equity interest) but not more than 25% of the board, and (2) another shareholder is a BHC company under the Bank Holding Company Act. In gauging proportionate interest, the investor should round to the nearest whole number such that a 15% total equity interest could provide two representatives on a ten person board. The Guidance states that the minority representative should not in any instance serve as the Chairman of the board or of a committee, but may serve on any committee proportionate to their overall board interest. Board observers also remain permissible.

Total Equity. As to total equity, the Guidance states that the FRB continues to believe that as a general matter an investor that owns more than 25 percent of the total equity of a banking organization has a controlling influence over the institution. However, the Guidance provides that the FRB would also permit a larger percentage of total equity if: (1) the voting and nonvoting shares, when aggregated represent less than one-third of the total equity; (2) the equity represents less than one third of any class of voting securities, assuming conversion of all convertible shares; and (3) the investor would not own 15 percent or more of any class of voting securities. The Guidance also provides that nonvoting shares that convert at the option of the holder or after the passage of time are considered voting shares for these purposes. However, shares that are nonvoting in the hands of the investor may continue to be transferred via a widespread public offering or other specified means.

Consultations with Management. The Guidance makes clear that a minority investor may communicate with management about, and advocate changes in, policies and operations. (e.g., dividends, mergers, and capital raising). The minority investor must limit its activities to voting its shares and exercising board privileges, however, and it should not threaten to dispose of shares or to sponsor a proxy solicitation.

Business Relationships. The Guidance provides that the FRB historically has precluded noncontrolling minority shareholders from having material business relationships with banking organizations. However, while the FRB still believes business relationships should not be material, it will allow certain relationships, particularly if voting securities are closer to 10 than 25 percent. The FRB will evaluate the size of the relationship, whether it is on market terms, is non-exclusive, and is terminable without penalty in making any determination as to materiality.

Covenants. The Guidance states that the FRB continues to believe that covenants that substantially limit the discretion of a banking organization’s management over major policies and decisions (e.g., hiring/firing senior officers, raising debt/equity, mergers or other major restructurings) “suggest the exercise of a controlling influence.” On the other hand, covenants consistent with the rights of a holder of nonvoting securities (as defined in Regulation Y), as well as covenants for limited information and consultation rights, should be permissible.

Implications for BHC Investors. The liberalization of the FRB’s guidance on minority investments in BHCs affords the private equity community both greater flexibility and greater certainty in structuring minority investments in BHCs. As a result the revised guidance has a number of implications for private equity investments in BHCs including:

  • Opportunity to Deploy Additional Economic and Intellectual Capital. The revised guidance encourages private equity funds to deploy greater amounts of economic capital through significantly increased ownership limits in BHCs as well as increased intellectual capital through board seats and informal management consultation. The revised guidance will likely encourage greater investment by private equity funds that are current BHC investors, but were previously artificially constrained from increasing their commitments. Moreover, additional interest in the sector by new BHC investors may be encouraged by the relaxed restrictions on equity positions and management participation. 

  • Enhanced Upside and Downside Protection Opportunities. The flexibility to take a higher ownership stake offers a private equity investor the opportunity to participate in a more meaningful way in the upside of its BHC investment as well as the opportunity to protect its downside risk through follow-on equity investments to support existing BHC portfolio companies. In turn, BHC’s should benefit from more meaningful participation by seasoned private equity investors in management deliberations.

  • Reduced Transaction Costs and Greater Certainty. Additional FRB guidance provides greater clarity around the parameters of permissible minority investments which should reduce the often considerable transaction costs of structuring BHC investments and clearing regulatory hurdles, (which should have the added benefit of reducing the time to close investments in this sector)