United States: Federal Reserve Board Adopts, Proposes Merchant Banking And Nonfinancial Investment Regulations

The new regulations, which were adopted on March 17, 2000, and made effective immediately on an interim basis, expressly allow a financial holding company which, among other things, has a registered broker-dealer subsidiary, to make merchant banking investments, a specifically-defined term in the new regulations which refers to investments in nonfinancial companies. In turn, a nonfinancial company is any company engaged in any activity which is not "financial" in nature, or incidental to a financial activity, under subsection 4(k) of the BHCA. These investments may be made either directly or through a private investment fund controlled by the financial holding company.

Types of Investments Allowed. A merchant banking investment can consist of shares, assets or ownership interests of any company or other legal entity, including any debt or equity security, warrant, option, partnership interest, trust certificate or other instrument representing an ownership interest in the company or entity.

Qualifying Private Funds. A financial holding company may make merchant banking investments through any qualifying "private equity fund," which is a fund not established for the purposes of evading, or making investments inconsistent with, the merchant banking authority of the BHCA, and that satisfies certain conditions, including conditions relating to numbers and types of investors, fund term and the like.

Holding Periods for Merchant Banking Investments. Merchant banking investments may be held for a period of time to enable the sale or disposition thereof "on a reasonable basis consistent with the financial viability of the financial holding company’s merchant banking investment activities." All merchant banking investments are subject to a general 10-year maximum holding period (absent prior Board approval for an extension), although any portfolio company investment made by a financial holding company in or through a private investment fund can be held for the duration of the fund. Special ownership "tack-on" rules apply to interests acquired or transferred by financial holding companies under these regulations.

Risk Management, Reporting and Record-Keeping Policies. A financial holding company is required to establish and maintain policies specifically designed to manage the risks associated with merchant banking investments, and must maintain appropriate records and supporting information which can be reviewed by the Board. A financial holding company also must file annual and quarterly reports regarding the nature and level of its merchant banking investments.

Cross-Marketing and Affiliate Transaction Restrictions. Depository institution subsidiaries of a financial holding company which makes merchant banking investments are subject to specific cross-marketing and affiliate transaction restrictions with respect to the parent holding company’s portfolio companies.

Investment Limits. Financial holding companies are limited, absent prior Board approval, in their aggregate merchant banking investments (measured according to carrying value) to (i) the lesser of 30% of the financial holding company’s Tier 1 capital or $6 billion, or (ii) the lesser of 20% of the financial holding company’s Tier 1 capital or $4 billion excluding interests in private equity funds.

Notice Procedures. A financial holding company need only provide a one-time notice within 30 days after its initial commencement of merchant banking activities, except for any acquisition of more than 5% of the interests of any portfolio company at a total cost exceeding the lesser of 5% of the financial holding company’s Tier 1 regulatory capital or $200 million, in which case a 30-day after-the-fact notice must be provided for each such investment.

The Board also has proposed for comment a regulation which would impose a 50% capital charge on any merchant banking investments (i.e., investments in nonfinancial companies pursuant to section 4(k)(4)(H) of the BHCA) made directly or indirectly by a financial holding company. This capital charge also would be imposed on bank holding companies making investments in nonfinancial companies under Regulation K, pursuant to section 4(c)(6) of the BHCA, through SBICs, or through state bank subsidiaries pursuant to section 24 of the Federal Deposit Insurance Act.

Specifically, a financial or bank holding company would be required to deduct from its Tier 1 regulatory capital an amount equal to 50% of the total carrying value of all covered investments held by the holding company. At the same time, the total carrying value of such investments would be deducted from the holding company’s assets for purposes of computing the asset denominator of the holding company’s risk-based and leverage capital ratios. The capital charge would apply to all investments of the financial or bank holding company that are deemed to be "equity" of the portfolio company and all debt instruments that are convertible into equity, as well as debt extended by the holding company to a portfolio company in which the holding company holds 15% or more of the other company’s equity (subject to certain exceptions).

During the period prior to the adoption of the proposed rule, financial holding companies engaged in merchant banking activities would be expected to adopt and implement internal capital and accounting policies that reflect the various risks associated with their investment activities. One criterion for the adequacy of such policies is that they be capable of enabling the financial holding company to meet the terms of the proposed capital rule on its effective date with minimal adjustment and remain in compliance with applicable regulatory capital standards.

The proposed capital adequacy rule, if adopted in substantially its current form, would have a potentially significant impact on banking organization investment activities involving nonfinancial companies, including merchant banking investments, direct bank investments, bank holding company investments under section 4(c)(6) of the BHCA, and foreign investments under Regulation K. Further, banking companies would be expected to have in place appropriate policies and procedures addressing the matters discussed in the previous paragraph pending the proposed rule’s adoption.

The Board’s interim rules and rule proposals have received substantial press, and have generated considerable controversy, in the case of the proposed capital rule. Banking organizations engaged in any significant venture capital, multitier finance, private investment fund investment or similar types of investment activities will benefit from the merchant banking authority codified in the new regulations, particularly in light of the Board’s decision to construe somewhat liberally the basic qualification requirements for firms proposing to engage in such activities by allowing any financial holding company which owns a registered broker-dealer to qualify for merchant banking authority. At the same time, interested organizations should bear in mind that these rules confer authority for financial holding companies to make nonfinancial investments, and cannot be used as a basis for making significant investments (passive or otherwise) in other financial companies. Further, the interim rule imposes a series of substantive and procedural preconditions for financial holding companies proposing to engage in merchant banking activities, including maximum holding periods for portfolio investments and aggregate investment limitations for the financial holding company, and financial organizations will need to be alert to the potential limiting effects of these preconditions. The Board has suggested that some of these requirements, however, may not be as necessary in the case of merchant banking investments conducted through private equity funds, and specifically has invited comment on this issue.

Of greater concern is the potential impact of the capital charges for merchant banking investments which would be imposed under the Board’s capital regulation, if adopted in its current form. Banking organizations have criticized the capital proposal as substantially undercutting the financial benefits conferred by the merchant banking provisions of Gramm-Leach-Bliley. The Board, at the same time, has indicated that the capital proposal is consistent with its understanding as to the nature and levels of internal capital changes self-imposed by financial services firms active in the merchant banking realm (according to its own surveys), so it is uncertain whether the Board will be swayed by the criticisms of affected financial organizations absent persuasive quantitative support demonstrating, for instance, that the proposed capital charges are excessive given the nature and extent of the risks posed by such activities.

Comments on both the interim regulations and the capital proposal are due by May 22, 2000, and interested organizations should actively consider commenting on these important developments. While the interim and proposed rules indicate that the Board already has devoted significant supervisory attention to the benefits and risks of merchant banking activities, in other respects the Board is creating a regulatory structure without the benefit of significant past practical experience in supervising these types of activities. Therefore, comments which provide the Board with specific information on relevant financial, risk management, operational or market practices in this area should be welcomed by the Board, and would stand the best chance of persuading the Board to make any changes in the interim and proposed rules already in the public domain.