Federal Reserve Relaxes Restrictions on Non-Controlling Investments

September 23, 2008

Yesterday, the Fed released its much-anticipated policy statement regarding non-controlling equity investments in banking organizations. The guidance provides some additional flexibility and greater clarity for PE groups, hedge funds and other investors seeking to make significant investments in banking organizations without becoming subject to Fed supervision as a bank holding company.

The Fed’s Changes

The key statutory limit restricting a non-controlling investor to 24.9% of voting securities of course remains, but the policy statement helps to loosen some restrictions on investors within this limit. Key changes from past Fed precedents include:

  • Permitting one director to any non-controlling investor that holds up to 24.9% of a banking organization’s voting securities. Prior precedents had permitted a director only when the investor held less than 10% or, where there was another larger investor, less than 15% voting.

  • Permitting two directors to a non-controlling investor if (a) the investor’s board representation is proportional to the greater of its voting interest or total equity interest in the banking organization, (b) the investor holds no more than 25% of the board seats, and (c) there is a larger, controlling shareholder that is regulated by the Fed as a bank holding company (e.g., a holder of 25% or more of a class of voting securities).

  • Permitting a non-controlling investor to own up to one-third of the total equity of a banking organization (and have director rights as described above) if the investor would hold (a) less than one-third of any class of voting securities when counting all convertible non-voting shares held by the investor as if converted, and (b) no more than 14.9% of any class of voting securities. Prior Fed precedents generally permitted non-controlling investors to own up to 25% of total equity.

  • Confirming explicitly the ability of non-controlling investors to communicate with management about, and advocate for changes in, any of the banking organization’s policies and operations (including, for example, advocacy for changes in management, strategies for raising additional debt or equity financing and urging a sale or merger). As before, an investor is not permitted any form of veto rights with respect to such issues, and the Fed cautions that an investor may not explicitly or implicitly threaten to dispose of its shares in the banking organization in connection with its advocacy of certain policies or operations.

Yesterday’s policy statement reaffirmed the Fed’s approach to convertible securities, including the ability to treat such securities as non-voting even if they are convertible into voting securities, as long as the ability to convert is limited to certain exit events such as a widely dispersed public offering.

What This Means for Investors

  • These changes will not alter significantly the basic strategies already used for non-controlling investments, but within those structures will increase the percentage of voting stock that can be held by investors seeking board representation. Minority investors that were previously forced to make a significant portion of their investment in non-voting preferred securities to stay below the 10% limit for having a director will now be able make a greater proportion of their investment in common stock, with corresponding potential upside advantages for the investor and regulatory capital advantages for the target bank.

  • In practice, few investors are likely to take advantage of the possibility of two directors, since most investments are made at the top-tier holding company of a banking organization where there is not a larger investor that is also a holding company. An exception would be when investors utilize a structure in which a lead investor creates a separate fund or vehicle that becomes a bank holding company and other minority investors come in simultaneously at lower levels.

  • The new guidelines apply only to banking organizations supervised by the Fed; investments in thrift organizations remain subject to the existing rules of the Office of Thrift Supervision regarding non-controlling investments. The Fed’s approach to control is now more flexible than OTS requirements in some respects, such as permitting an investor to contribute up to 33% of capital in some circumstances, and permitting more than one director under circumstances where the OTS would require a rebuttal agreement limiting board representation to one director.

In addition to the principal changes outlined above, the policy statement suggests a number of other subtle differences from past Fed precedents that may be helpful in specific circumstances. If you would like to discuss the new guidance in greater detail, please feel free to contact any member of our Financial Institutions or Private Equity Groups in any of our offices worldwide.