September 26, 2008

Noncontrolling Investments in Banking Organizations

On Monday, as Morgan Stanley and Goldman Sachs were being reorganized into bank holding companies, the Board of Governors of the Federal Reserve System issued a new policy statement on equity investments in banks and bank holding companies to liberalize which investments are deemed “noncontrolling” (and thus don’t subject investors to the Bank Holding Company Act of 1956).

As a Sullivan & Cromwell memo notes: the areas of liberalization include ownership of voting shares, director representation, total equity investment and convertible securities. The policy statement does not, however, deal with two other key, and arguably more important, issues: “club” investments and “silo” funds. Consequently, it remains to be seen whether the policy statement will facilitate substantial additional private equity investments in banks. In addition, the policy statement may facilitate shareholder activism.

A Gibson Dunn memo summarizes the policy’s changes as follows:

1. Director Representation – An investor may have at least one representative on a BHC’s board of directors. It may also have two representatives “when the investor’s aggregate director representation is proportionate to its total interest in the banking organization [that is, the greater of the investor’s voting interest or total equity in the organization], but does not exceed 25 percent of the voting members of the board, and another shareholder of the banking organization is a [BHC] that controls the banking organization under the BHC Act.” (footnotes omitted).

2. Increased Maximum Investment – An investor may own “a combination of voting and nonvoting shares that, when aggregated, represents less than one-third [33%] of the total equity of the organization (and less than one-third of any class of voting securities, assuming conversion of all convertible nonvoting shares held by the investor) and does not allow the investor to own, hold or vote 15 percent or more of any class of voting securities of the organization.”

3. Enhanced Consultations with Management – An investor may communicate and advocate with management for changes in a BHC’s policies or operations such as policies related to mergers, management changes, dividends, debt or equity financing, new business lines, and subsidiary divestitures. An investor may not make explicit or implicit threats to dispose of shares in the BHC or to sponsor a proxy solicitation as a condition of action or non-action by the BHC or its management in connection with these policy discussions.

We have posted memos on this development in our “Bank M&A” Practice Area.