May 21, 2015

So, You Want to Invest in a Bank or Bank Holding Company . . .

Joseph E. Silvia

Perhaps one of the most important components of any capital raise or acquisition involving banks and their holding companies is the involvement of the Federal Reserve and the broader regulatory process. A proposal to raise money or acquire another institution may trigger filing obligations under the Bank Holding Company Act (BHCA), the Home Owners Loan Act (HOLA), or the Change in Bank Control Act (CIBCA) and their implementing Regulations Y and LL. Each of these statutes and regulations includes time frames and publication requirements that institutions need to be aware of when planning for the closing of a transaction.

For example, a filing made under Section 3 of the BHCA is generally a 30-day process with the relevant Federal Reserve Bank on a delegated basis; however, this 30 days may be delayed based on a multitude of factors that raise additional questions from the Federal Reserve. Alternatively, a notice filed pursuant to the CIBCA is generally a 60-day process, once a complete application is received by the relevant Federal Reserve Bank. However, complex structures, ratings issues, or protests may all require that the filing be transferred out of the hands of the relevant Federal Reserve Bank to the Federal Reserve Board (the “Board”) in Washington, D.C., for review. This transfer to the Board can significantly alter the expected time frame for approval, which will depend in large measure on getting the requested information to the Board staff in a timely and complete manner.

The goal of this article is to provide a brief overview of the questions and analyses that need to be considered by investors and acquirers prior to making an investment or seeking to purchase a bank or bank holding company supervised by the Federal Reserve. There are also filing obligations and additional considerations with respect to institutions supervised by other federal and state regulatory agencies, but the focus here is on the Federal Reserve. As you will see, there are a number of questions that need to be asked from the outset to make the regulatory process as smooth and predictable as possible for investors and acquirers.

Who, What, and How Much?

When making an initial determination about what potential filing obligations exist with the Federal Reserve, investors and acquirers should consider the answers to a number of threshold questions, including, but not limited to:

  1. What does the structure of the transaction look like?
  2. Is a BHC buying another BHC?
  3. Is an outside investor making a large investment?
  4. Is there a newly established company being formed for the limited purpose of making an investment?
  5. Is there a group of investors seeking to make an investment as part of the same offering?
  6. Who is buying what? Equity? Debt? and
  7. How much are they buying? 

Reviewing the answers to these questions can provide a roadmap of issues to review under the BHCA, HOLA, or CIBCA. 

Who is the Investor/Acquirer? 

The identity of the investor or acquirer can be a relatively simple question, but the answer can significantly complicate the transaction. For example, investing in an individual capacity can certainly limit the exposure of the investor to issues under the BHCA, but it all depends on the facts and circumstances of the investment. Based on the particular facts, it could be that a number of individuals are investing at the same time and based on the same or very similar terms. In that case, the investors should each consider whether their corresponding investments create an association or similar organization under the BHCA and Regulation Y. The investors should also determine whether their concerted activity could make them a group acting in concert subject to filing requirements under the CIBCA and Regulation Y. Additionally, on an individual basis, investors need to be aware of the relevant thresholds associated with filing obligations under the CIBCA and Regulation Y, as discussed below.

If the investment is made through an entity, there are another multitude of questions to answer with respect to the entity itself. Most importantly is whether the company may be deemed to be a bank or savings and loan holding company under the BHCA and Regulation Y or HOLA and Regulation LL. Many investors make the incorrect assumption that, as long as they invest in less than 25 percent of the banking organization, they will not control the organization and therefore, there is no filing obligation or need to consider the regulatory process for such investments.

However, there are various thresholds and regulatory requirements associated with ownership levels well below 25 percent. Indeed, the only presumption that a company is not a bank holding company exists where the company owns less than 5 percent of the voting securities of a bank or bank holding company. This means that any investment or acquisition of shares that results in the investor or acquirer owning more than 5 percent of the voting securities of a bank or bank holding company needs to be reviewed for compliance with the BHCA, HOLA, and CIBCA filing obligations.

What is the Investor/Acquirer Purchasing?

Another critical question to ask at the outset is: what is being purchased? This is absolutely key to setting the expectations of the regulatory process at the early stages. These questions include whether the investor or company is purchasing an equity stake. What kinds of securities are being purchased? Are they voting? Nonvoting? Are the securities really nonvoting, as defined in Regulation Y? What are the actual rights and preferences of such securities? Are they purchasing debt, such as subordinated debt? Is there a combination of equity and debt being purchased? What is the total equity position of the investment post-consummation?

The answer to what the investor/acquirer is actually purchasing will help determine whether any filings are required since the definitions of control in the BHCA and CIBCA generally refer the acquisition of voting securities. Therefore, it follows that the ownership of strictly nonvoting securities would not implicate issues of control under the BHCA or CIBCA. Of course, attempting to avoid control by acquiring only nonvoting shares requires confirmation that the securities are in fact nonvoting, as that term is defined in Regulation Y.

Regulation Y states that “[p]referred shares, limited partnership shares or interests, or, similar interests are not “voting securities” if:

(i) Any voting rights associated with the shares or interest are limited solely to the type customarily provided by statute with regard to matters that would significantly and adversely affect the rights or preference of the security or other interest, such as the issuance of additional amounts or classes of senior securities, the modification of the terms of the security or interest, the dissolution of the issuing company, or the payment of dividends by the issuing company when preferred dividends are in arrears; (ii) The shares or interest represent an essentially passive investment or financing device and do not otherwise provide the holder with control over the issuing company; and (iii) The shares or interest do not entitle the holder, by statute, charter, or in any manner, to select or to vote for the selection of directors, trustees, or partners (or persons exercising similar functions) of the issuing company.

See 12 CFR 225.2(q)(2).

Of course, where an investor will be acquiring both voting and nonvoting securities, the Board will review the overall investment for control purposes. In this case, the policy statement on equity investments in banks and bank holding companies (2008 Policy Statement) is instructive. The 2008 Policy Statement, which is publicly available on the Board’s website and was never codified, outlines some general guidelines for equity investments and control. For example, the 2008 Policy Statement appears to contemplate a permissible noncontrolling investment where an investor “owns a combination of voting and nonvoting shares that, when aggregated, represents less than one-third of the total equity of the organization . . . and does not allow the investor to own, hold or vote 15 percent or more of any class of voting securities of the organization.” See 2008 Policy Statement.

The 2008 Policy Statement continues with a discussion of nonvoting shares that are convertible into voting shares. Here, the Board indicates that such nonvoting shares should generally be “considered to be voting shares at all times for purposes of the BHCA.” However, the Board left open the door for certain nonvoting convertible shares to be viewed as truly nonvoting under very limited circumstances. Such circumstances exist where the nonvoting shares are not convertible in the hands of the investor and can only be transferred by the investor (i) to an affiliate of the investor or to the banking organization; (ii) in a widespread public distribution; (iii) in transfers in which no transferee (or group of associated transferees) would receive 2 percent or more of any class of voting securities of the banking organization; or (iv) to a person that already controls more than 50 percent of the voting securities of the banking organization. See 2008 Policy Statement.

Therefore, it is clear that understanding what the investor or acquirer is purchasing is critical to determining what filing obligations may or may not exist with the Federal Reserve.

What Triggers a Filing With the Federal Reserve?

Based on the responses to the questions presented above, investors and acquirers will be able to engage in perhaps the most important analysis on the front end – a control analysis. Determining control as it relates to the BHCA, HOLA, and CIBCA early on in the process will avoid unnecessary delay and headache later when the Federal Reserve staff has become fully engaged in asking questions and understanding the potential transaction and control implications. This analysis may also avoid unpleasant conversations during the process about potential regulatory hurdles.

Control Under the Bank Holding Company Act

Generally, a filing is required under the BHCA where a “company,” as that term is defined in Regulation Y at 12 CFR 225.2(d), takes any action that causes it to become a bank holding company, most commonly by seeking to acquire control of a bank or bank holding company. See 12 CFR 225.11. Here, the definition of “control” under the BHCA is critical. Under the BHCA and its implementing Regulation Y, control of a bank or other company means:

(i) Ownership, control, or power to vote 25 percent or more of the outstanding shares of any class of voting securities of the bank or other company, directly or indirectly or acting through one or more other persons; (ii) Control in any manner over the election of a majority of the directors, trustees, or general partners (or individuals exercising similar functions) of the bank or other company; (iii) The power to exercise, directly or indirectly, a controlling influence over the management or policies of the bank or other company, as determined by the Board after notice and opportunity for hearing . . . ; or (iv) Conditioning in any manner the transfer of 25 percent or more of the outstanding shares of any class of voting securities of a bank or other company upon the transfer of 25 percent or more of the outstanding shares of any class of voting securities of another bank or other company.

See 12 CFR 225.2(e)(1).

Under the BHCA, definitions are key. For example, the definition of “company” includes entities such as employee stock option plans, trusts that are not deemed to be testamentary trusts, as defined in Regulation Y, and other business associations. Moreover, investors and acquirers should be aware of the definitions of voting securities and nonvoting shares, as well as what a “class” of voting securities means. See 12 CFR 225.2(q). Each of these definitions is critical in both the control analysis under the BHCA and the CIBCA.

Control Under the CIBCA 

A filing under the CIBCA is generally required where a person, defined as an individual, trust or any form of entity in Regulation Y, “acting directly or indirectly, or through or in concert with one or more persons,” acquires control of a bank or bank holding company, unless the transaction is otherwise exempt under 12 CFR 225.42. In any case where a company is proposing to own or control more than 25 percent of the voting securities of a bank or bank holding company, filing will be made under the BHCA, not the CIBCA.

However, specifically with regard to the CIBCA, “[t]he acquisition of voting securities of a state member bank or bank holding company constitutes the acquisition of control under the [CIBCA], requiring prior notice to the Board, if, immediately after the transaction, the acquiring person (or persons acting in concert) will own, control, or hold with power to vote 25 percent or more of the voting securities of the institution.” See 12 CFR 225.41(c)(1). Therefore, the first prong of control is the threshold of 25 percent of the voting securities of the bank or bank holding company. The second prong, the rebuttable presumption of control under the CIBCA, is more nuanced.

Under the second prong for control, the Federal Reserve:

presumes that an acquisition of voting securities of a state member bank or bank holding company constitutes the acquisition of control under the [CIBCA], requiring prior notice to the Board, if, immediately after the transaction, the acquiring person (or persons acting in concert) will own, control, or hold with power to vote 10 percent or more of any class of voting securities of the institution, and if (i) the institution has registered securities under section 12 of the Securities and Exchange Act of 1934 (12 USC 78l); or (ii) no other person will own, control, or hold with power to vote a greater percentage of that class of voting securities immediately after the transaction.

See 12 CFR 225.41(c)(2).

This second prong is significant for investors. If an investor will own more than 10 percent of the voting securities of a banking institution, and that banking institution either has its securities registered under section 12 of the Securities and Exchange Act or the investor will own more than any other shareholder, then that investor (or group acting in concert) will likely have a filing obligation under the CIBCA rebuttable presumption. Investors and acquirers must take care to mind CIBCA filing obligations and the rebuttable presumption, which can be very difficult to rebut if the investment triggers the relevant thresholds.

What Could Slow Down or Delay the Regulatory Approval Process?

1.      Public Comments and Protests

Filings under the BHCA and CIBCA generally require the investor or acquirer to publish an announcement of the proposal in a newspaper of general circulation in the communities in which the acquirer and/or target operate. Included in the publication is language that refers to the proposal and the interested parties, but also an indication that the public is welcome to submit comments to the relevant Federal Reserve Bank. Where substantive negative comments or protests are received by the relevant Federal Reserve Bank, the application is generally sent to the Board for review and will likely be removed from a delegated review at the Federal Reserve Bank until the comments or protests are resolved, if possible.

Unfortunately, there appears to be an increasing number of proposals receiving comments which may delay consummation. In most cases, the Board finds the comments to be substantive, which initiates a process to resolve the underlying issues to the Board’s satisfaction. However, the Board’s process for determining whether a comment is substantive is less clear and can create frustration on the part of the acquirer and the target hoping to close the deal.

2.      Foreign Investors

Where an investment or acquisition proposal involves money coming from foreign investors investing either individually or through a company, applicants should expect a longer time frame for getting approval. In these cases, the Federal Reserve takes a very careful review of the foreign investors on an individual basis, as well as any entity involved and its investors. The goal of this review is to understand who is making the investment or who controls the entity making the investment. In many cases, there are a number of additional questions asked by Federal Reserve staff to understand, among many other things, the nature of the investment and the potential investors.

For example, the Federal Reserve will likely inquire about the businesses each of the investors may be otherwise involved with, what the source of funds for each investor may be, how the foreign investors came to learn of the investing opportunity, whether the investors should be grouped together for purposes of the CIBCA, what other potential investments an investing entity has made in the past and currently has outstanding, and whether the investing entity should be considered a bank or savings and loan holding company based on size or nature of the investment being made. Each of these inquiries takes time to resolve and can serve to frustrate the investment process if they are not handled at the outset.

3.      Certain Operating Covenants in Transaction Documents

As many practitioners have discovered, the Federal Reserve staff is concerned with certain operating covenants, generally negative covenants, which restrict a target from engaging in the normal and ordinary course of its business between the date the agreement is executed and the date the agreement is consummated. Here, the Federal Reserve is concerned that an acquirer has the ability to exert an inappropriate amount of control over the target prior to receiving the approval from the Federal Reserve to consummate the transaction. The idea is simply that the acquirer should not be able to control the target prior to receiving approval from the Federal Reserve to do so.

In the past, there have been a number of operating covenants and other provisions that give the Federal Reserve staff heartburn over the potential control implications prior to approval. While not each of these provisions makes its way into every discussion or additional information request sent by the Federal Reserve, each of them is likely reviewed carefully by staff for considerations of control. The covenants and other provisions that commonly cause heartburn for Federal Reserve staff include provisions that restrict the ability of the target engage in its normal and ordinary course of business. For example, such provisions may include those restricting the target from hiring or firing management, engaging in new lines of business, making or renewing loans or other extensions of credit, issuing dividends, and changing auditors, among others.

Where the Federal Reserve takes issue with a one of these covenants, the Federal Reserve staff will generally look to three options to resolve the issue, although they will likely not indicate a preference, only that the prior control issues need to be resolved prior to approval. First, the staff may request additional information in terms of the relevant data or background to find out whether the provision actually restricts the normal and ordinary course of business of the target. Second, the Federal Reserve staff may request that the acquirer commit, to the Board, that it will not enforce the provisions at issue prior to receiving approval. Third, the Federal Reserve may offer that the acquirer could amend or remove the provision implicating issues of prior control in the transaction documents themselves. Investors and acquirers will need to review each of these options to determine the best for the transaction.

4.      Supervisory Issues at the Acquirer or the Target

Another area that can cause a great deal of delay comes where the acquirer or the target has outstanding supervisory issues, whether it is a poor or less than satisfactory composite or individual rating. As we have seen with some acquisition proposals that have been reported in financial news outlets, this is especially the case where the acquirer or the target has a less than satisfactory rating with regard to consumer compliance, Community Reinvestment Act compliance, or Bank Secrecy Act/Anti-Money laundering compliance.

Conclusion

Clearly, potential investors in and acquirers of banks and bank holding companies subject to Federal Reserve oversight have a laundry list of considerations when weighing an investment or acquisition, not the least of which will be the regulatory process. Investors and acquirers need to be absolutely clear on whether the investment or acquisition is being made on an individual basis or through a company, what the structure of the investment actually is, and whether the investment triggers a filing obligation with the Federal Reserve under the BHCA, HOLA, or CIBCA.

Joseph E. Silvia

Joseph E. Silvia is senior counsel at Locke Lord LLP in Chicago.