It would be a gross understatement to say that the United States banking industry has a substantial need for capital. Every quarter, and often more frequently than that, comes news of additional asset writedowns at US banks, particularly those with extensive exposure to the housing market. Analysts predict continuing writedowns and a corresponding need for capital. One source of such capital is private equity firms, which, over the last decade, have been extremely successful in attracting funding from a wide variety of sources. Although every bank regulator will say that capital is king in times of stress, current Federal Reserve Board (FRB) regulations and interpretations pose obstacles to contributions from private equity firms to the US banking industry. These regulations and interpretations can be modified without sacrificing bank safety and soundness or the policy concerns behind the Bank Holding Company Act.
Regulations
In the first instance, it is necessary to understand the statutory schemes relevant to private equity investments in US banks and thrifts. Which scheme (and which regulator) is relevant depends on the type of charter of the institution. If the institution is an FDIC-insured or state-chartered bank, the relevant statute will be the Bank Holding Company Act of 1956 and the relevant regulator the Board of Governors of the Federal Reserve System (FRB). If the institution is a thrift (a federally-chartered savings bank, an FDIC-insured state-chartered savings and loan association or state-chartered savings bank), the relevant statute will be the Savings and Loan Holding Company Act and the relevant regulator the Office of Thrift Supervision (OTS). US banks and thrifts alike have recently needed substantial capital infusions. Good examples are National City Corporation, the holding company for an FDIC-insured national bank, National City Bank, and Washington Mutual Inc, the holding company for Washington Mutual Bank, an FDIC-insured federal thrift.
For a private equity firm, both the Savings and Loan Holding Company Act and the Bank Holding Company Act are of serious concern because no private equity firm wants to be regulated as a holding company under either statute. In addition to the intrusion of being subject to supervision by the OTS or FRB and mandated restrictions on private equity activities, holding companies for banks and thrifts can be called on by their regulators to be a source of strength to their subsidiary depository institutions in times of trouble. Historically, particularly with respect to bank holding companies regulated by the FRB, the source of strength doctrine has been open-ended, leaving a bank holding company with no ability to predict what resources it may be called on to commit to support its bank subsidiaries.
Interpretations
Whether a private equity firm becomes a bank holding company or a savings-and-loan holding company depends on whether it has control of a bank or a thrift according to the FRB's interpretation. The Bank Holding Company Act defines control as: (i) directly or indirectly owning, controlling or having the power to vote 25% or more of any class of voting securities of a bank or bank holding company; (ii) controlling in any way the election of a majority of directors or trustees of a bank or bank holding company; or (iii) directly or indirectly exercising a controlling influence over the management and policies of a bank or bank holding company. The Savings and Loan Holding Company Act's definition is very similar.
There are substantial differences, however, in regulatory interpretations of what constitutes a controlling influence over the management and policies of an investee company. In practice, the FRB will generally find that the following factors constitute control: (i) 10% or more voting share ownership if the investor has a right to appoint a director to the bank or bank holding company's board; (ii) total equity (voting and nonvoting equity, including as equity any subordinated debt) ownership of more than 24.9% even in the absence of a director right; and (iii) depending on the circumstances of the investment, ownership of more than 14.9% or, in rarer circumstances, 19.9%, total equity if the investor has a right to appoint a director to the bank or bank holding company's board.
The OTS's control regulation, by contrast, speaks in terms of rebuttable presumptions of control that allow for greater flexibility in structuring investments. For control to be presumed, an acquirer must: (i) either acquire more than 10% of any class of voting stock, or more than 25% of any class of stock, of a thrift or its holding company; and (ii) be subject to a control factor such as being one of the two largest holders of any class of voting stock, holding more than 25% of total stockholders' equity, holding more than 35% of combined debt securities and stockholders' equity, or being able to appoint more than one member to the board of directors. Because these presumptions are rebuttable, a private equity firm can acquire more than 10% of the voting shares of a thrift holding company, have the right to a director on the company's board and be one of the two largest voting shareholders, provided that it enters into an agreement with the OTS under which it agrees to be a passive investor. FRB practice generally imposes a hard stop at 9.9% voting share ownership if the investor has the right to a board seat, which private equity firms generally do require.
Restrictions
The FRB has frequently imposed other restrictions that undercut an investor's flexibility when structuring an investment. Warrants exercisable into voting stock are often counted as the latter for purposes of the 10% voting stock test, no matter how far out of the money they are. Non-voting shares that are convertible at the holder's option at a later date or upon a future event are often counted as voting shares from the inception of the investment. When determining share percentages, the FRB often counts the warrants of the investor as voting shares, but identical warrants held by other investors will not be counted as such. Finally, veto rights by the investor company must be substantially limited. If permitted at all, they are most often restricted to matters that the FRB considers those on which an equity holder may vote without its interest being deemed voting. That is, matters traditionally permitted to preferred shares under state statute for matters that would significantly and adversely affect the rights or preferences of the interest, such as the issuance of additional amounts or classes of senior securities, the modification of the terms of the investor's security or the dissolution of the bank or bank holding company.
Other similarly conservative interpretations of the statute that would pose difficulties for a private equity fund seeking to come to the aid of a distressed bank or bank holding company are also theoretically possible. For example, one way for a private equity fund to obtain greater flexibility to hold additional voting or non-voting stock is to separate the investment into two (or more) independent co-investments. That is, the fund itself makes an under-10% voting share investment in the bank or bank holding company (with perhaps additional non-voting shares) and separate vehicles not controlled by the fund but holding the interests of certain fund shareholders make similar investments, with the separate vehicles retaining independent rights to vote and transfer their shares. From publicly available information, such a structure was implemented in the case of the JC Flowers Fund's investment in HSH Nordbank, a German bank regulated as a bank holding company as a result of its US branch office. The investment comprised shares that were entitled to more than 25% of the votes, and the structure allowed the Flowers Fund to avoid regulation as a bank holding company.
In implementing such a structure, it is important that no fund shareholder that owns 25% or more or otherwise controls the separate vehicle be seen as controlling the private equity fund itself. Otherwise, the shareholder will be understood to be making an aggregated investment through the separate vehicles, the private equity fund and the independent vehicle. Going back to the FRB's control interpretations, consider the likely result if a fund shareholder that can be said to control the separate vehicle owns more than 9.9% of the private equity fund. One might perhaps take solace in the view that the shareholder's interests in the fund are non-voting, because generally such interests are limited partnership or limited liability company interests that are entitled to vote on very little. But one cannot take such solace: if the fund shareholder can vote on nothing other than the replacement of the fund's general partner, the fund interests will be considered voting. As a result, if the shareholder that controls the separate vehicle owns more than 9.9% of the fund, one then has to consider whether other connections between the shareholder and the fund itself raise concerns about the shareholder's control.
It is therefore apparent that the FRB imposes a conservative view of control: in determining whether such an approach should prevail, one must consider the reasons for the control tests under the relevant statutes. The purpose of the Bank Holding Company Act is to separate banking and commercial activities in the US, based on the view that a concentration of banking and commercial resources poses dangers to the economy as a whole. If a company controls a bank or bank holding company within the meaning of the Bank Holding Company Act, it must register as a bank holding company with the FRB and its nonbanking activities are restricted. It may not make investments in commercial companies except 5% or less voting share investments (with some additional non-voting equity also permitted), or, if the company qualifies as a financial holding company, up to 100% voting share investments as long as it disposes of the investments within a reasonable time (10 to 15 years) and does not routinely manage or operate the commercial companies invested in.
What, then, about the Savings and Loan Holding Company Act? Until 1999, it was permissible for a holding company, as long as it controlled only one savings association, to be engaged in any form of commercial activity. However, this so-called unitary thrift holding company loophole was closed (subject to grandfathering) in 1999. As of that date, thrift holding companies have been subject to the same restrictions on commercial company ownership as bank holding companies. The statutes, therefore, have the same fundamental purposes.
Private equity funds are, in a crucially fundamental way, different from purely commercial companies in that they do not seek to hold their interests in commercial companies for an extended period of time. A private equity fund seeking to make a capital contribution to a FRB-regulated bank holding company does so with the hope of selling its interest at a profit before the end of the fund's life (which may be in as little as five years). This is a very different situation than that of a nationwide retailer seeking to acquire an FDIC-insured bank so that it may have banking offices in every store or, for example, a car manufacturer acquiring an FDIC-insured bank in order to make car loans nationwide. The most recent and fundamental revision to the Bank Holding Company Act (in 1999) recognised precisely this point: the Gramm-Leach-Bliley Act determined that, when conducted within certain limitations, private equity activities are not commercial activities but rather activities financial in nature. Significant financial institutions regulated as bank holding companies can now all make investments in commercial companies as long as they do not engage in the routine management and operation of those companies and dispose of their investments within a reasonable time. Private equity properly understood, therefore, does not lead to an improper mixing of banking and commerce, in Congress's view.
Possible reforms
With this in mind, what reforms could the FRB implement for private equity firms in its control interpretations? It could allow a private equity firm to have more than 10% voting shares of a bank or bank holding company and one director in appropriate circumstances, as long as a proper passivity arrangement were entered into. It could allow a private equity firm to have 9.9% voting share ownership and 24.9% total equity and one director, in appropriate circumstances. In addition, the FRB could: (i) liberalise its views and treat warrants as voting shares only when there is a reasonable probability of an investor exercising them; (ii) apply a more flexible approach to shares convertible into voting shares (if they are optionally convertible but only on the occurrence of certain events, they should be treated as voting shares only on the occurrence of those events); and (iii) treat every investor's (not just the private equity firm's) warrants as exercised when calculating voting share percentages. In terms of investments structured as separate co-investments, the FRB could agree not to treat fund interests as voting interests unless they have substantially more voting power than simply over replacing the general partner or managing member of the fund, as this would allow private equity funds much greater flexibility when deciding which of their investors to solicit when making an independent co-investment in a bank or bank holding company. Finally, the FRB could consider viewing private equity vetoes over certain fundamental, non-ordinary course business transactions as consistent with non-control, notwithstanding that votes on such matters are generally not given to preferred shareholders under state corporate law.
Liberalise it
Because this is a troubled time for banks and thrifts, it will be tempting as a matter of regulatory policy to rein in any such liberalising interpretations to situations involving a distressed depository institution. However, careful thought should be given before yielding to any such temptation. Although capital is king at times of distress, it is hard to think of a good reason to deprive depository institutions of important sources of US domestic capital even in good times.
There is another policy justification for such a liberalisation in terms of maintaining and increasing competition in the US banking industry. In the last decade, there have been many successful US banks, usually at the local or regional level, that have been sold to larger institutions. With each sale, portions of experienced business and management teams decline to move to the acquiring institution, but they have a wealth of experience that can be drawn on. Matched with understanding private equity investors, these experienced bankers can create new depository institutions, providing consumers and businesses with increased choice. In doing so, many of the other policies of the Bank Holding Company Act recognised by the FRB in its regulations (avoiding the concentration of financial resources, increasing competition and promoting gains in efficiency and consumer convenience) would be advanced. These benefits to the public argue in favour of welcoming private equity in good times as well as bad. There is no good reason, once private equity investments in banks are recognised as consistent with the separation of banking and commerce, to interpret the Bank Holding Company Act as undercutting its other key policy goals.
By Arthur S Long of Davis Polk & Wardwell
On January 1 2009 some changes to the German Foreign Trade and Payments Act (Außenwirtschaftsgesetz, AWG) will come into effect that are likely to have a significant impact on foreign investors wishing to invest in German target companies. Under the new regime, any such acquisition by foreign investors may trigger the right of the German Federal Ministry of Economics to investigate and even prohibit the transaction.
The reform
Who is affected?
Under the Foreign Trade and Payments Act, investors from non-EC countries that do not belong to the European Free Trade Association (EC plus Switzerland, Norway, Iceland and Liechtenstein) and that acquire shares representing 25% or more of the voting stock of a German company may have their acquisition investigated by the Federal Ministry of Economics. Shares held by companies controlled by the acquirer (by holding at least 25% of the voting stock) are treated as if they were held by the acquirer itself. Shares that are subject to voting agreements are also assigned to the acquirer.
If the Ministry comes to the conclusion that Germany's public order or national security are threatened by a transaction, it may prohibit the acquisition. Unfortunately, the Act does not contain any definition of public order or national security, so the Act brings a certain degree of uncertainty about which transactions fall within its scope. If the Ministry decides that a transaction falls within the scope of the Act, it may order that the acquisition (which may already be consummated) be reversed. The Ministry may also choose only to prohibit the exertion of voting rights of shares held by the foreign investor, thus restricting the investor's influence on the German target.
How long does it take to reach a decision?
Foreign investors are under no obligation to file their transaction with the Federal Ministry of Economics. However, they may do so after signing and will, in that case, receive a final decision on whether the transaction will be prohibited within one month. If the transaction is not filed with the Ministry, it may start an investigation on its own account within three months after the consummation of the transaction, with the effect that the transaction is put under the condition precedent of the Ministry's approval. The Ministry will immediately inform the investor of its decision to investigate the acquisition, which triggers the acquirer's obligation to provide the Ministry with data. The acquirer will be informed about the specific data required by the Ministry through an announcement in the Federal Gazette (Bundesanzeiger). The investigation must be completed within two months of receipt of the transaction data.
Aims and criticism
The reform seeks to protect sensitive branches of German industry such as the energy, telecom and military sectors. Potential threats are perceived to come from state-controlled funds (in particular from China, the Emirates and Russia) that may be used to influence German politics via investments in German key enterprises. State-controlled foreign corporations have also been classified as potentially dangerous.
The reforms have attracted much criticism. For example, the new powers granted to the Ministry of Economics are suspected of infringing the freedom of capital movement as guaranteed by Article 56 of the EC Treaty. The European Commission is planning to examine the Act for its reconcilability with Article 56 and the freedom of establishment (Article 49). Also, the scope of the Act is considered to be unreasonable because it not only restricts investment from foreign countries, state-owned funds or state-controlled corporations but foreign investors in general. Any private equity investor wishing to invest in Germany may find his transaction being investigated by the Federal Ministry of Economics.
The problem for foreign investors
The main problem is the legal uncertainty for foreign investors. If an investor has successfully completed a transaction, it may still be subject to investigation for a period of three months after the closing date. A further two months may pass until the Ministry has completed its investigation. The result may be that the transaction is prohibited and the acquisition must be reversed. This uncertainty is unacceptable for the seller, buyer, target, financing banks and employees of the target company.
Recommended course of action
Foreign investors wishing to acquire 25% or more of the voting stock of a German company should therefore adhere to the following guidelines.
Informal enquiry before signing
A foreign investor can contact the Federal Ministry of Economics before he signs a share purchase agreement on a confidential and informal basis in order to find out if the Ministry will investigate the transaction. A similar approach is generally taken if a bidder wishes to know the position of the German Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) on a takeover process. There are no guidelines on how such an informal approach should be made, though any informal contact bears the risk that information may be leaked. A seller is therefore unlikely to agree to such contact.
Filing for investigation after signing
Therefore, a foreign investor should voluntarily file the transaction with the Federal Ministry of Economics immediately after signing a share purchase agreement. He should refrain from filing only if he and the seller are in no doubt that the transaction does not qualify for an investigation by the Ministry. If the investor intends to file the transaction, the share purchase agreement should contain a clause that makes the clearance of the acquisition by the Ministry a condition precedent for the obligation of the parties to consummate the transaction. After the Ministry has received all relevant data, it has one month to decide whether it will prohibit the consummation. In order to speed up the process, the investor should agree with the Ministry on which information it needs in order to come to a decision as quickly as possible. It appears likely that an investor will, in most cases, be able to get a decision before the German Federal Cartel Authority (Bundeskartellamt) has cleared the transaction. Therefore, the filing of the acquisition should not lead to delay in most cases.
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