The Federal Reserve Posts “Capital Welcome!” Sign and Opens the Gate a Little Wider for Noncontrolling Investments in Banks by Private Equity Firms and Others
T.J. Mick Grasmick
Among the flurry of proposals and pronouncements by the banking and securities regulators intended to calm the troubled financial market waters and restore credibility and liquidity was the long-rumored, but modest relaxation by the Federal Reserve of its policy on equity and non-equity investments in banks that will not subject the investor to supervision, regulation and examination as a bank holding company. Whether and when the new Federal Reserve policy, which is likely to be followed by the other regulatory agencies, may result in significant new private equity investment in bank capital remains to be seen.
Since the 1980s the Federal Reserve has allowed combinations of voting equity and total capital investments between 10% and 15% and up to 24.9%, subject to restrictions on having a director on the board and otherwise avoiding several identified indices of control that may allow the investor to otherwise exercise a controlling influence over the management or policies of a banking organization (e.g. having executive management positions; seeking to influence lending practices, growth decisions or dividends; and opposing management’s director nominee slate). Private equity investors who take more than 9.9% voting interest will generally need to receive nonobjections from the applicable bank regulatory agency by providing so-called “passivity commitments” or entering into a Rebuttal of Control Agreement.
This BankingLaw@manatt newsletter summarizes the basic issues and rules, identifies what has changed and what has not changed; and then offers some background history and perspective and comments on the potential impact of the new Federal Reserve policy statement.
WHAT HAVE BEEN THE BASIC RULES FOR NONCONTROLLING INVESTMENTS IN BANKS?
Except as discussed below, these basic rules have not changed.
WHAT DOES THE NEW FEDERAL RESERVE POLICY STATEMENT CHANGE?
The new Federal Reserve Policy Statement (12 CFR 225.144) makes three principal modifications to the situations which the Federal Reserve previously viewed as evidencing a controlling influence:
SOME HISTORICAL BACKGROUND AND PERSPECTIVE
The bank regulatory parameters on noncontrolling investments in banks and the origin of the passivity commitments dates back to the early 1980s concern over bank “stake out” investments in banks in other states prior to the fall of most of the barriers on interstate banking. However, the most well-known case setting the barriers on noncontrolling investments in banks involved the proposed investment by The Sumitomo Bank, Ltd. in Goldman, Sachs & Co. in 1986 that would have equaled 30% of Goldman Sachs’ total equity capital. The control issue was addressed in the context of the separation of commercial banking from investment banking--barriers which mostly fell with the enactment of the Gramm-Leach-Bliley Act in 1999. What a difference two decades make as last week the financial markets were encouraged by the announcement that Warren Buffet’s Berkshire Hathaway investment conglomerate will make a noncontrolling $5 billion investment in Goldman Sachs as a new bank holding company.
Most private equity, hedge and sovereign wealth funds will not or cannot seek control approval due to: (i) the regulatory effects of controlling an insured U.S. depository institution—including capital requirements, examination and supervision, the obligation to serve as a source of financial and managerial strength and limits on affiliate transactions with the bank; or (ii) the continued U.S. limits on mixing banking and commerce by prohibiting commercial (non-financial) firms from controlling commercial banks. Accordingly, private equity investments of 9.9% or less voting stock without other indices of control are common as a “safe harbor” to avoid a control determination inquiry by a banking agency. However, multiple contemporaneous investments by independent, nonaffiliated investors must be structured carefully to avoid inquiry as to whether multiple investors are a group acting in concert which requires prior approval under the Bank Holding Company Act or the Change in Bank Control Act.
Separate funds have been structured to seek approval to control a banking organization without the fund investors being deemed to be acting in concert and thus subject to regulation and supervision (e.g. the Federal Reserve’s approvals of the Bear Stearns-arranged Doral Financial, Puerto Rico, recapitalization and the JLL Associates-coordinated acquisition of control of FC Holdings’ banks in Texas).
The engagement of experienced bank counsel and early informal consultation with the appropriate state and federal banking agencies is imperative for both the private equity investor and the banking organization to avoid missteps in structuring deals and damage to regulatory relationships.
WHAT IS THE EXPECTED IMPACT OF THE NEW POLICY STATEMENT?
The Federal Reserve’s more relaxed fit policy has been under consideration and discussions with private equity funds for two years or more. This means that the interest in larger equity plays in banks arose when bank earnings were stellar and M&A opportunities were plentiful. Banks were often viewed as new “portfolio company” investment opportunities that offered short term high returns without long term commitments. A different appetite is required now when bank earnings prospects are in the cellar and new capital is needed just to remain well or adequately capitalized. Some private funds have already watched their investments in banks decline dramatically in value. Other funds have kept their powder dry. Old terminology is resurfacing (“buyout firms” and “vulture funds”), along with the prospect of private equity investments riding the recovery upside as was the case for some investors after the late 80s and early 90s savings and loan industry debacle.
Banking organizations contemplating new capital offerings that might otherwise cap voting investments at 9.9% in order to avoid bank regulatory complications, may want to be more flexible on the amount of private equity capital they will accept from investors who may now be more comfortable with the new policy statement. Given the recent dizzying speed of developments, we may know soon whether the new Federal Reserve policy statement will accelerate capital investments in banks by private equity funds and other such investors and what strategies they will pursue.
 Under the Bank Holding Company Act, a company has control over a bank or a bank holding company if the company (i) directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25% or more of any class of voting securities; (ii) controls in any manner the election of a majority of the directors; or (iii) directly or indirectly exercises a controlling influence over the management or policies of a bank or bank holding company.
 Control of Utah and Nevada (but not California) industrial banks not considered commercial banks remains available for non-financial investors, subject to the FDIC’s ability to retain jurisdiction over the last charter loophole allowing banking and commerce to mix.
 The OTS has separate but similar policies and procedures for acquiring control of savings banks or savings and loan holding companies since the unitary savings and loan holding company ownership of saving banks by non-financial firms was halted by the Gramm-Leach-Bliley Act.
Questions on the foregoing may be addressed to T.J. Grasmick at Manatt, Phelps & Phillips, LLP, in Los Angeles at 310-312-4369 and by email to firstname.lastname@example.org. The firm website at www.manatt.com also has other Newsletters and White Papers on investments in U.S. banks, as well as a description of the breadth and special expertise of the many attorneys in the Banking & Specialty Finance Practice Area.
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T.J. Mick Grasmick Mr. Grasmick's practice focuses on mergers and acquisitions, non-banking activities, formation of new banks, interstate and other expansion by banks, bank holding companies and other financial institutions and the requirements and restrictions on expansion of state and federal bank regulatory agencies; bank supervision and examination, and general banking corporate matters and regulatory and legislative developments.
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