Depository Institutions Alert

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1 October 2008 Authors: Rebecca H. Laird Sean P. Mahoney Edward G. Eisert Ira L. Tannenbaum K&L Gates comprises approximately 1,700 lawyers in 28 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, visit Non-Controlling Investments in Banking Institutions and Their Holding Companies The recent turmoil in the financial markets has caused many investors to contemplate opportunities for making investments in banks and bank holding companies notwithstanding that such investments are subject to extensive regulation. Much of that regulation centers around the issue of whether an investor or investor group would be deemed to have control over a subject bank or holding company. Under applicable law, control can be triggered by an acquisition of much less than a majority voting interest. These standards, as interpreted and enforced by federal bank regulatory authorities, are restrictive. Some have argued they are too tough and discourage investment in banks and holding companies at a time when these organizations desperately need to attract additional capital. In response to these concerns, on September 22, 2008, the Board of Governors of the Federal Reserve System (the FRB ) modified its guidance on the standards for determining whether or not a minority investor controls a bank or bank holding company. (See Policy Statement on Equity Investments in Bank and Bank Holding Companies, dated September 22, 2008, 12 CFR (the Policy Statement )). Earlier in the year, the Office of Thrift Supervision ( OTS ) updated its views on noncontrolling investments in thrifts and thrift holding companies in connection with its acceptance of Rebuttals of Control and Concerted Action with respect to investments in Washington Mutual, Inc., Guaranty Bank, E*TRADE Financial Corporation and H&R Block. The Federal Deposit Insurance Corporation (the FDIC ) applies its own view of control under the change in Bank Control Act to companies seeking to invest, directly or indirectly, in FDIC-insured industrial loan companies. The Office of the Comptroller of the Currency (the OCC ) also applies its own views on control to national banks involved in a change of control. This Alert discusses each agency s views on noncontrolling investments involving depository institutions and their holding companies. 1 Why Does Control Matter? Historically, investors in depository institutions and their holding companies have sought to avoid investments that would be considered controlling under the federal Change in Bank Control Act (the CIBC Act ), applicable to depository institutions not owned by a holding company, the Bank Holding Company Act of 1956 (the BHC Act ), applicable to bank and financial holding companies, and the Savings and Loan Holding Company Act (the SLHC Act ), applicable to thrift holding companies. Control of a depository institution, either directly or indirectly, can lead to limitations on the activities of the controlling company, requirements to support financially the subsidiary depository institution, and also subject transactions between the depository institution and the affiliates of the controlling investor to certain restrictions. Moreover, control of a depository institution generally subjects the investor to registration with either the FRB or OTS as a bank, financial, or thrift holding company, with ongoing regulation and oversight by the appropriate federal bank regulator, and reporting and other requirements. 2 Statutory Provisions Each of the CIBC Act, BHC Act and SLHC Act defines control to include the power to vote 25% or more of any class of voting securities of an institution subject to such statute. Further, each statute also provides that control can exist independent of stock ownership. For example, control under the CIBC Act also includes the power to direct the management or policies of an insured depository institution. Similarly, an investor has control under the BHC Act if the investor controls in any

2 manner the election of a majority of the directors, or the FRB determines that the investor exercises a controlling influence over management. The SLHC Act provides that an investor controls a thrift or thrift holding company if the investor controls in any manner the election of a majority of the directors of such institution, or if the OTS determines that the investor exercises a controlling influence over such institution. Control of a thrift holding company under the SLHC Act also exists if the investor has contributed more than 25% of the capital of the company. The one explicit statutory standard on non-controlling investments comes in the BHC Act, which provides a presumption that any company that owns, controls, or has power to vote less than 5% of any class of voting securities of a bank or bank holding company does not control that institution. The issue of control becomes murky when the investment is more than 5% but less than 25% of any class of voting securities of a banking institution or its holding company. To deal with the gray area between the two numerical poles in the statutes, the regulatory agencies have adopted rebuttable presumptions of control which exist when an investor owns, holds or controls 10% of more of the voting securities of a banking institution or holding company, the bank or other company has registered securities under the Securities Exchange Act of 1934 and no other person will own, control, or hold the power to vote a greater percentage of that class of voting securities. The FRB and OTS apply additional presumptions of control. 3 If control is presumed, an investor generally must make a filing with the applicable regulator to rebut control. Such filing will usually include an agreement or commitments that are consistent with the regulator s understanding of how a passive, non-controlling investor would behave. FRB Control Concepts With respect to investments in banks or in bank holding companies, the FRB routinely has found that an investor that owns less than 25% of any class of voting securities of a bank or bank holding company does not control the institution if the investor makes certain commitments (referred to as Crownx Commitments ) to remain passive. These undertakings include commitments to refrain from, among other things: seeking or accepting representation on the board of directors of the subject bank or holding company or any of their respective subsidiaries, unless the investment is less than 15% of any class of outstanding voting securities and the investor is not the largest investor of the subject bank or holding company; attempting to influence major policies or plans of the subject bank or holding company; and entering into any other banking or non-banking transactions with the subject bank or holding company or any of their respective subsidiaries, other than de minimis transactions. The Policy Statement provides investors additional flexibility in structuring an investment without being deemed to acquire control of the bank or bank holding company. The Policy Statement allows investors to do the following without being deemed to control the bank or bank holding company in which the investment is made: have one director on the board of the bank or bank holding company; have two directors on the board of the bank or bank holding company if such representation does not constitute 25% or more of the voting directors and another shareholder of the bank or bank holding company is a bank holding company that controls such institution; own up to one-third of the total equity capital of the bank or bank holding company provided that the investor does not own, hold or vote more than 15% of the outstanding shares of any class of voting securities of the institution; engage in discussions with management over major policies; engage in business transactions with the bank or holding company on a limited basis, as reviewed on a case-by-case basis, and generally on market terms, nonexclusive and terminable without penalty; and invest in non-voting securities, subject to covenants prohibiting the target bank or holding company from issuing senior securities, changing the security terms or liquidating the organization. In summary, the Policy Statement provides additional flexibility in structuring non-control investments. Nevertheless, minority non-controlling investments in banks and bank holding companies cannot provide to investors many of the features of other private equity investments, such as the ability to exercise a controlling influence over major policies or strategic decisions. October

3 OTS Control Concepts The OTS, like the FDIC and the OCC, has long allowed investors to own more than 10% of the outstanding voting shares of a thrift or thrift holding company (e.g., up to 25% of the outstanding voting shares), provided that the investor rebutted control by submitting a rebuttal of control in writing and by entering into a standardized rebuttal agreement, set out in the OTS regulations. A rebuttal of control is generally filed when an investment reaches 10% of any class of voting securities of a thrift or thrift holding company and another control factor is present. As in the case of the Crownx Commitments, the standard rebuttal agreements provide that the investor will not, among other things: seek or accept representation through more than one member of the board of directors of the thrift or thrift holding company; engage in any intercompany transaction with the target thrift or thrift holding company or any of its affiliates; have or seek to have any representative serve as the chairman of the board of directors, or chairman of an executive or similar committee; or seek or accept access to any non-public information concerning the thrift or thrift holding company. Recent orders by the OTS have evidenced flexibility in applying the model terms of the OTS form of rebuttal agreement. For example, investors in Washington Mutual, Inc. were permitted to acquire 24.99% of the voting power of that company, have representation on the board of directors by one director and have a right to another non-voting observer, without being deemed to control the company. With respect to E*TRADE Financial Corporation, the OTS permitted investors to seek or accept access to non-public information so long as such information was not material. The order pertaining to Guaranty Bank permitted the subject thrift to engage in transactions with companies in which the investor owned less than 10% of the outstanding voting securities. The Acceptance of Rebuttal of Control pertaining to H&R Block, Inc., a thrift holding company, permitted the investor to engage in certain intercompany transactions with H&R Block where such transactions were entered into on an arm s-length basis, in the ordinary course of business and at market rates and terms. While the OTS has already shown flexibility in structuring non-controlling investments in thrifts, it remains to be seen whether the Policy Statement will affect how the OTS views control in the future. FDIC Control Concepts Against the backdrop of applications filed by retailers to acquire industrial loan companies in recent years, the FDIC proposed regulations in early 2007 to regulate for the first time companies that control industrial loan companies. These regulations specifically address control issues by incorporating regulations promulgated under the CIBC Act. In recent approval orders relating to the acquisition of industrial loan companies by companies that are not bank holding companies, the FDIC has also required investors owning more than 10% but less than 25% of the voting shares of the acquiring company to execute passivity agreements. These agreements provide that the FDIC would not find the investor to control the target industrial loan company if the investor refrained from the following, among other things: having more than one representative on the board of directors of the parent company or any of its subsidiaries, so long as the investor does not have any representatives on the board of the bank; or entering into any other banking or non-banking transactions with the target bank or holding company or any of their respective subsidiaries, other than de minimis transactions. The FDIC passivity agreements appear to be modeled after the FRB Crownx Commitments. This has become more important as significant investments in commercial firms that own industrial loan companies (e.g., Harley- Davidson, Inc. owns an industrial loan company) may pose issues for investors in those companies. It remains to be seen whether the FDIC will revise its form of passivity agreement to conform to the new standards set forth in the Policy Statement. OCC Control Concepts The OCC regulates national banks, including full-service banks, limited purpose trust companies and certain credit card banks. With respect to investments in commercial firms that control national credit card banks (e.g., retailers) or national trust companies, or other national banks that are not wholly-owned by a bank holding company or financial holding company, the OCC would have the regulatory authority to determine whether such investments constitute control. In its Change in Bank Control manual, the OCC describes the commitments that it requires in connection with a rebuttal of control in connection with an investment in a national bank. October

4 These commitments include that: the investor will not serve on the board of directors and will not nominate any candidate to serve on the board of the national bank; the investor will have only limited contacts with bank management that are customary for interested shareholders; and the investor will engage only in normal and customary banking transactions with the bank. As of the date of this writing, the OCC has not indicated whether it will revise its control concepts to accord the same flexibility provided by the FRB and the OTS. The Landscape Remains Complex Even with welcome developments providing greater clarity and flexibility to investors in structuring minority equity investments in depository institutions and their holding companies, the legal landscape remains complex and somewhat uncertain. The rules and procedures applied still differ from regulator to regulator as do presumptions of control. Each investment must be analyzed individually based upon the specific facts presented and there is unlikely to be a universal approach that will work with all investments and institutions. Above all else, regulators continue to remind investors that they retain the discretion to make decisions on a case-by-case basis. October

5 Endonotes 1 Many states also have laws regulating changes in bank control or who can control banks and other financial institutions. 2 Control of certain entities, such as industrial loan companies, credit card banks and limited purpose trust companies, does not require the controlling owner to register as a holding company under the BHC Act because those entities are not considered banks under the BHC Act. 3 The other presumptions of control under regulations promulgated by the FRB are as follows: A company controls the bank or other company if it enters into any agreement or understanding with a bank or other company (other than an investment advisory agreement), such as a management contract, under which the first company or any of its subsidiaries directs or exercises significant influence over the general management or overall operations of the bank or other company. A company that, together with its management officials or controlling shareholders (including members of the immediate families of either), owns, controls, or holds with power to vote 25% or more of the outstanding shares of any class of voting securities of a bank or other company controls the bank or other company, if the first company owns, controls, or holds with power to vote more than 5% of the outstanding shares of any class of voting securities of the bank or other company. A company that has one or more management officials in common with a bank or other company controls the bank or other company, if the first company owns, controls or holds with power to vote more than 5% of the outstanding shares of any class of voting securities of the bank or other company, and no other person controls as much as 5% of the outstanding shares of any class of voting securities of the bank or other company. The OTS also presumes control if the acquiror owns more than 10% of any class of voting securities of a thrift or thrift holding company and any one of the following factors is present: The acquiror would be one of the two largest holders of any class of voting stock of the thrift; The acquiror would hold more than 25% of the total stockholders equity of the thrift; The acquiror would hold more than 35% of the combined debt securities and stockholders equity of the thrift; The acquiror is party to an agreement: (a) pursuant to which the acquiror possesses a material economic stake in the thrift resulting from, among other things, the provision of essential services to the thrift; or (b) that enables the acquiror to influence a material aspect of the management or policies of the thrift (subject to certain exceptions); The acquiror would have the ability, other than through the holding of revocable proxies, to direct the votes of more than 25% of a class of the thrift s voting stock or to vote more than 25% of a class of the thrift s voting stock in the future upon the occurrence of a future event; The acquiror would have the power to direct the disposition of more than 25% of a class of the thrift s voting stock in a manner other than a widely dispersed or public offering; The acquiror and/or the acquiror s representatives or nominees would constitute more than one member of the thrift s board of directors; or The acquiror or a nominee or management official of the acquiror would serve as the chairman of the board of directors, chairman of the executive committee, chief executive officer, chief operating officer, chief financial officer or in any position with similar policymaking authority in the thrift. K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, in Beijing (K&L Gates LLP Beijing Representative Office), and in Shanghai (K&L Gates LLP Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998 We may contact you from time to time with information on K&L Gates LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please london@klgates.com if you would prefer not to receive this information K&L Gates LLP. All Rights Reserved. October