Merchant Banking Investments: Balancing Portfolio Oversight With Operating Restrictions

Merchant banking authority granted under the Gramm-Leach-Bliley Act gives Financial Holding Companies (“FHCs”) – superstar Bank Holding Companies that elect to become FHCs – powerful investment capabilities, but it comes with a fundamental tension. Under 12 CFR 225.171, an FHC may not “routinely manage or operate” a portfolio company held under merchant banking authority. Yet, as any experienced investor knows, some level of oversight is essential to protect the investment.

Permissible Covenants and Restrictions

The Federal Reserve recognizes this tension and permits certain protective covenants. Covenants restricting the portfolio company from engaging in activities outside the ordinary course of business are generally permissible. The standard is contextual: the significance of any restriction depends on the nature of the restriction and the size, capital condition, business type, and characteristics of the portfolio company.

As a general rule, actions that would normally require board-of-directors approval would also be permissible subjects for FHC covenant protections. This aligns FHC oversight authority with standard corporate governance practices.

Holding Period Rules

Merchant banking investments are subject to strict holding periods: generally 10 years, or 15 years for qualifying private equity fund investments.

Several timing rules apply:

• If the FHC acquired the investment before becoming a BHC/FHC, the holding period starts on the date it became an FHC.
• When an FHC acquires from another (unaffiliated) FHC, the holding period generally starts at the date of acquisition.
• When acquired from an affiliate, the “tacking” rule under 12 CFR 225.172(b)(2)-(3) applies — the original acquisition date carries over.

Failure to divest within the applicable holding period can result in enforcement action or other regulatory challenges. Accurate tracking of acquisition dates, especially through affiliated-party transfers, is therefore essential.

DM Tip: FHCs should maintain detailed timelines and documentation for each merchant banking investment, including acquisition dates and any affiliated-party transfers, to accurately track holding periods and avoid regulatory violations. Contact us for a review of your merchant banking investments, timelines, and documentation.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.