Financial Services Alert - September 23, 2008

The FRB published guidance (the “Guidance”) on minority investments in banks and bank holding companies (“BHCs”).  The Guidance can be used by private equity firms, sovereign wealth funds and other minority investors in banking institutions.  The Guidance states that the FRB also will use the principles it articulated in the Guidance to analyze investments by BHCs in nonbanking firms.  The Guidance largely clarifies the FRB’s position on certain issues, but also provides greater leniency in certain areas as well.

Historical Approaches.  The Guidance provides historical background on the FRB’s reasoning, focusing particularly on the limitations on ownership, management direction and share transfer set forth in the 1982 Policy Statement on Nonvoting Equity Investments by Bank Holding Companies.  The Guidance also discusses the passivity commitments certain relatively large investors enter into to avoid a control determination.

Specific Approaches to Avoid Control.  The Guidance then discusses specific approaches that minority investors can reference to avoid control.

Directors.  Historically, the FRB generally has not allowed a minority investor with over 10 percent of the voting stock of a banking institution to also have a board member on the institution.  Noting that bank boards generally have 9-10 members, the Guidance states that a single representative should not create a controlling influence.  Moreover, the Guidance provides that even 2 representatives would be permissible provided that:  (1) the representation is proportionate to the investor’s total interest (i.e., greater of voting interest or total equity interest) but not more than 25% of the board, and (2) another shareholder is a BHC company under the Bank Holding Company Act.  In gauging proportionate interest, the investor should round to the nearest whole number such that a 15% total equity interest could provide two representatives on a ten person board.  The Guidance states that the minority representative should not serve as the Chairman of the board or of a committee, but may serve on a committee proportionate to their overall board interest.  Observers also remain permissible.

Total Equity.  As to total equity, the Guidance states that the FRB continues to believe that as a general matter an investor that owns more than 25 percent of the total equity of a banking organization has a controlling influence over the institution.  However, the Guidance further provides that the FRB would also permit a larger percentage of total equity if:  (1) the voting and nonvoting shares, when aggregated represent less than one-third of the total equity; (2) the equity represents less than one third of any class of voting securities, assuming conversion of all convertible shares; and (3) the investor would not own 15 percent or more of any class of voting securities.  The Guidance also provides that nonvoting shares that convert at the option of the holder or after the passage of time are considered voting shares for these purposes.  However, shares that are nonvoting in the hands of the investor may continue to be transferred to another via a widespread public offering or other specified means.

Consultations with Management.  The Guidance also makes clear that a minority investor may communicate with management about, and advocate changes in, policies and approaches and operations.  (e.g., dividends, mergers, and capital raising).  The minority investor must limit its activities to voting its shares and exercising board privileges, however, and it should not threaten to dispose of shares or to sponsor a proxy solicitation.

Business Relationships.  The Guidance provides that the FRB historically has precluded noncontrolling minority shareholders from having material business relationships with banking organizations.  However, while the FRB still believes business relationships should not be material, it will allow certain relationships, particularly if voting securities are closer to 10 than 25 percent.  The FRB will evaluate the size of the relationship, whether it is on market terms, is non-exclusive, and is terminable without penalty.

Covenants.  The Guidance also states that the FRB continues to believe that covenants that substantially limit the discretion of a banking organization’s management over major policies and decisions (e.g., hiring/firing senior officers, raising debt/equity, mergers or other major restructurings) “suggest the exercise of a controlling influence.”  On the other hand, covenants consistent with the rights of a holder of nonvoting securities (as defined in Regulation Y), as well as covenants for limited information and consultation rights, should be permissible.

As Monday’s Federal Reserve Board policy statement on minority equity investments in banks and bank holding companies reaffirms, private equity firms are keenly interested in both majority and minority investing in this space.  Our latest event, Private Equity Investing in Banks: Opportunities in a Perfect Storm, to be held in New York on Oct. 2 at the Parker Meridien Hotel, will examine the latest trends in this sector of the M&A market.  Several private equity funds are being raised to invest in the banking industry, while a growing number of banking institutions are considering acquisitions, selling minority stakes or putting themselves up for sale.

Join some of the biggest names in the industry and hear from experts from both the M&A and banking communities.  The conference will be anchored by keynote speaker Randy Quarles, Managing Director with The Carlyle Group, and former Under Secretary of the Treasury, followed by a panel discussing this evolving sector featuring Alison Davis, Managing Partner at Belvedere Capital, Michael McClintock, Managing Director at Friedman Billings Ramsay and Joseph Thomas, Managing Director at Hovde.

The Federal Reserve Board approved (the “Morgan Approval”) the application of Morgan Stanley (“Morgan”) and two of its subsidiaries to become bank holding companies (“BHCs”) upon the conversion of Morgan’s Utah industrial loan company subsidiary, MS Bank to a national bank.  MS Bank has FDIC-issued deposits.  The FRB also approved Morgan’s request to retain its voting shares of a federal savings association and a limited purpose national bank that engages solely in trust or fiduciary activities.

In a second order (the “Goldman Approval”) released at the same time as the Morgan Approval, the FRB approved the application of The Goldman Sachs Group, Inc. (“Goldman”) and one of its subsidiaries to become BHCs upon the conversion of Goldman’s Utah, FDIC-insured, industrial loan company subsidiary, Goldman Sachs Bank USA (“Goldman Bank”), to a state-chartered bank.

In both the Morgan Approval and the Goldman Approval, the FRB determined that because of recent turmoil in the financial markets “emergency conditions exist that justify expeditious action” on the Morgan and Goldman applications.  Because neither application involved the acquisition, merger or consolidation of a bank, no five-day antitrust waiting period prior to consummation of either transaction was required.

Morgan filed and Goldman expects promptly to file an election with the FRB to become a financial holding company.  Both Morgan and Goldman, under the Bank Holding Company Act (the “BHC Act”), will have two years to conform their nonbanking investments and activities to the requirements of Section 4 of the BHC Act, with the possibility of three one-year extensions.

Morgan and Goldman are the last two major independent investment banks that are not BHCs.  Upon completion of the transactions, as BHCs, Morgan and Goldman will be subject to FRB oversight, but will gain increased access to FRB funding and will have increased opportunities to expand their base of stable deposits through acquisitions or otherwise.

Last week, with one large money market fund “breaking a buck” and another electing to close and liquidate when faced with significant redemption requests, the Federal government proposed several measures designed to assist money market funds in maintaining a stable net asset value per share.  Many of these proposals are in preliminary stages, and the only publicly available information describing them is from press releases.  This article briefly summarizes those proposals.

Guarantee of Money Market Funds by the Treasury.  The U.S. Treasury has proposed generally to guarantee the $1 share price of a publicly offered, retail or institutional money market fund registered under the Investment Company Act of 1940 (the “1940 Act”) that complies with Rule 2a-7 under the 1940 Act if the net asset value per share of the money market fund falls below $1.  The guarantee would apply only (a) after the money market fund’s board elected to liquidate the fund and (b) if in the absence of the program, shareholders would receive less than $1 per share.  The maximum amount payable under the program is $50 billion, all of which would come from the Exchange Stabilization Fund (the “ESF”) established by the Gold Reserve Act of 1934.  The program would be closed after one year.

Other important features of the program, as currently proposed by the Treasury are:  money market funds are not compelled to participate in the program; those money market funds that do participate are required to pay a fee (which has not been determined); and only “non-government, non-agency” money market funds may participate (but it is not clear whether a fund may participate if it holds both corporate and government securities).  In addition, under the Treasury program, the guarantee would not be capped for any one investor, i.e., there would be no limit on the protection offered each fund investor comparable to the $100,000 per depositor limit that applies to FDIC-insured bank accounts.  To eliminate any incentive for investors to move their deposits out of bank accounts and into money market mutual funds, however, the guarantee would be limited to balances that existed as of the close of business on Friday, September 19, 2008.

The Treasury also issued Notice 2008-81, effective September 22, 2008, in which it announced that tax-exempt money market funds may participate in the program without violating Section 149(b) of the Internal Revenue Code of 1986.  Section 149(b) generally prohibits federal guarantees of tax-exempt bonds.  The Notice also states that Federal tax authorities will not assert that the program impairs a money market fund’s ability to designate exempt-interest dividends or a money market fund shareholder’s ability to treat those distributions as exempt from federal income tax.

The principal Treasury press releases relating to this program may be found here: http://www.treas.gov/press/releases/hp1147.htm and: http://www.treas.gov/press/releases/hp1151.htm.  A copy of Notice 2008-81 may be found here: http://www.irs.gov/pub/irs-drop/n-08-81.pdf.

Legislative Alternative to Treasury Guarantee Program.  On Monday, September 22, 2008, Senator Christopher Dodd (Dem., Connecticut), Chairman of the Senate Banking Committee, proposed an alternative to, among other things, the Treasury’s program to assist money market funds.  Under Senator Dodd’s proposal as it relates expressly to money market funds, the Treasury could use the ESF temporarily, but would be prohibited from using the ESF once legislation is passed for that purpose, and the Treasury would have to reimburse the ESF for any expenditure it caused the ESF to make to a money market fund under the program.  In addition, the Treasury would be permitted for 120 days to guarantee money market funds as a part of the program, and for up to a year from the date of enactment, if the Treasury certifies the need to Congress.  Senator Dodd’s proposal also would require that any guarantee provided to money market funds under the program may not exceed FDIC coverage amounts (with certain exceptions, $100,000 per depositor per financial institution, although it is not clear from the Senator’s proposal whether a financial institution, for the purpose of the program, is an individual money market fund or one or more money market funds managed or sponsored by the same investment manager).  Finally, under the Senator’s proposal, the Treasury must charge money market funds participating in the program fees at a rate equivalent to the rates that the FDIC charges federally insured banks.

A summary of Senator Dodd’s proposal, as well as a draft bill reflecting that proposal, may be found here: http://banking.senate.gov/public/index.cfm?Fuseaction=Articles.Detail&Article_id=0e1cd224-b6e7-446d-a8fb-e96c7ebc7f24.

FRB to Purchase Agency Debt.  On September 19, 2008, the Federal Reserve Bank of New York (the “FRB-NY”) announced that the Open Market Trading Desk will begin purchasing short-term debt obligations issued by the Federal National Mortgage Association (“FannieMae”), the Federal Home Loan Mortgage Corporation (“FreddieMac”), and the Federal Home Loan Banks.  As stated by the FRB-NY, “purchases … will be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions via the [Open Market Trading] Desk’s FedTrade system.”  The goal of the program is to bring back liquidity into the agency market by reducing primary dealers’ holdings of those securities.  Although this buy-back program will not be limited to agency securities held by money market funds, money market funds that have significant positions in agency securities are intended beneficiaries.  The FRB states that the program is expected to expire on January 30, 2009.

The FRB’s press release relating to this program may be found here: http://www.newyorkfed.org/newsevents/news/markets/2008/rp080919.html.

FRB Lending Program to Help Finance the Purchase of Asset Backed Commercial Paper from Money Market Funds.  The FRB also announced on September 19, 2008 that it is instituting a new lending program that is intended, among other things, to assist money market funds in obtaining liquidity to meet redemptions by enabling them to sell some of their secured assets at amortized cost.  The lending facility will be administered for the FRB by the Federal Reserve Bank of Boston (the “FRB-Boston”).  Under the program, U.S. depository institutions and bank holding companies may borrow from a liquidity facility established by the FRB to purchase from any fund that qualifies as a money market fund under Rule 2a‑7 under the 1940 Act, eligible asset-backed commercial paper under certain conditions.  Any advance under the program is non-recourse to the FRB-Boston, and secured by the asset‑backed commercial paper purchased with the loan proceeds.  Among other things, only asset‑backed commercial paper that is a “First Tier Security,” as that term is defined under Rule 2a-7 (generally, the commercial paper must be rated by at least two nationally recognized statistical rating companies, at the time of pledge, in their highest short-term ratings categories), are eligible for purchase under the program.  The interest rate applicable to the loans will be equal to the primary credit rate in effect on the initiation date of the loan.  For eligible borrowers that are not depository institutions, advances remain outstanding for the remaining term of the asset‑backed commercial paper.  For eligible borrowers that are depository institutions, the advance and the maturity of the underlying pledged commercial paper may not exceed 120 days.

In addition, the FRB adopted interim regulatory exemptions for member banks from certain provisions of Sections 23A and 23B of the Federal Reserve Act and the FRB’s Regulation W.  These interim exemptions will increase the capacity of a member bank to purchase asset backed commercial paper from affiliated money market funds in connection with the new lending program. 

The FRB states that the program is expected to start immediately, and it is expected to expire on January 30, 2009, unless extended by the FRB.

The FRB’s press release relating to this program may be found here: http://www.federalreserve.gov/newsevents/press/monetary/20080919c.htm.

SEC Clarifies that Support for Money Market Funds Does Not Require On-Balance Sheet Reporting.  On September 17, 2008, the Office of the Chief Accountant of the SEC clarified that a financial institution’s support of a money market fund generally does not require the institution to present the money market fund on the institution’s balance sheet provided that the financial institution does not absorb the majority of the expected future risk associated with the fund’s assets.  Those risks may include interest rate, liquidity, credit and other relevant risks that are expected to impact the value of the money market fund’s assets.  The SEC staff, however, expects adequate disclosure of the nature of any support provided.

The SEC’s press release concerning the accounting treatment of bank support for money market funds may be found here: http://www.sec.gov/news/press/2008/2008-205.htm.

The U.S. Court of Appeals for the Second Circuit (the “Appeals Court”) found that a Connecticut law regulating refund anticipation loans (“RALs”) is preempted for national banks and tax preparation firms or other third parties working with national banks to make RALs.  Pacific Capital Bank v. Connecticut, 2d Cir., No. 06-4149-cv (Sept. 12, 2008).  The Connecticut statute, Conn. Gen. Stat. § 42-480 (“RAL Statute”), was challenged by Pacific Capital Bank, N.A. (“Pacific Capital”), a California-based national bank having no offices in Connecticut.  Pacific Capital made RALs to Connecticut residents largely through tax preparation firms located in the state.  California law did not limit the interest rates on RALs and a typical Pacific Capital RAL had an annualized interest rate of approximately 115%. 

The RAL Statute regulates a RAL “facilitator,” a term excluding a national bank.  A facilitator is subjected to a number of requirements with regard to RALs including limits on interest that may be charged, disclosures to borrowers, and limits on where RALs may be made.  In 2005, the Connecticut Attorney General issued an opinion letter stating that the provisions of the RAL Statute are not applicable to national banks, but are not preempted for loans made by a national bank through a facilitator.

Pacific Capital challenged the RAL Statute on the grounds that the law impairs the ability of a national bank to make loans by placing an effective ceiling on interest that may be charged.  The district court found that the RAL Statute was preempted for national banks and their third party facilitators with respect to limitations on the place where a RAL may be made.  The district court also found that the interest limit must be altered to allow national banks to make loans, including through their third party facilitators, at interest rates otherwise permitted.

The State of Connecticut appealed as to (1) Pacific Capital’s standing to challenge the RAL Statute and (2) the lower court ruling that the National Bank Act can preempt a state statute that regulates only non-banks and interpreting part of the RAL Statute as inapplicable to facilitators assisting national banks.  The Appeals Court found that Pacific Capital had standing to challenge the law because an indirect injury is sufficient to meet the standing requirement.  Finding that the RAL Statute was in irreconcilable conflict with federal law, the Appeals Court, citing the 2007 Watters decision by the U.S. Supreme Court, found the RAL Statute preempted for national banks and the facilitators working with national banks.  The Appeals Court noted that “[i]f a state statute subjects non-bank entities to punishment for acting as agents for national banks with respect to [a] particular [National Bank Act]-authorized activity and thereby significantly interferes with national banks’ ability to carry on that activity, the state statute does not escape preemption on the theory that, on its face, it regulates only non-bank entities.”

The FRB, FDIC, OCC and OTS (the “Agencies”) announced that they are evaluating proposed amendments (the “Proposed Amendments”) to generally accepted accounting principles related to accounting treatment of securitization and other structured finance activities.  Specifically, the Proposed Amendments being reviewed by the Agencies are proposed changes to the Financial Accounting Standards Board’s (“FASB”) FAS 140 concerning “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” and FIN 46(R), a FASB interpretive ruling concerning “Consolidation of Variable Interest Entities.”

The Proposed Amendments would eliminate the concept of a qualified special purpose entity (“QSPE”) from FAS 140 and require that variable interest entities previously accounted for as QSPEs be analyzed to determine whether they must be consolidated in accordance with Fin 46(R).  Moreover, the Proposed Amendments would revise the criteria for reporting a transaction as a sale rather than as a financing.  Furthermore, the Proposed Amendments would modify FIN 46(R) guidance concerning which enterprise, if any, would consolidate a variable interest entity.  Finally, the Proposed Amendments would require banking organizations to make additional disclosures concerning securitization and other structured finance activities.

The Agencies stated that they are evaluating the Proposed Amendments to determine the potential impact that the Proposed Amendments could have on banking organizations’ financial statements, regulatory capital, and other regulatory requirements.  The Agencies did not announce a deadline for the completion of their review of the Proposed Amendments.