federal reserve system department of the treasury...to merchant banking regulation, office of...

Tuesday,

March 28, 2000

Part II

Federal ReserveSystemDepartment of theTreasury12 CFR Parts 225 and 1500Bank Holding Companies and Change inBank Control; Interim Rule and ProposedRule

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16460 Federal Register / Vol. 65, No. 60 / Tuesday, March 28, 2000 / Rules and Regulations

FEDERAL RESERVE SYSTEM

12 CFR Part 225

[Regulation Y; Docket No. R–1065]

DEPARTMENT OF THE TREASURY

Office of the Under Secretary forDomestic Finance

12 CFR Part 1500

RIN 1505–AA78

Bank Holding Companies and Changein Bank Control

AGENCIES: Board of Governors of theFederal Reserve System and Departmentof the Treasury.ACTION: Interim rule, with request forpublic comments.

SUMMARY: The Board of Governors of theFederal Reserve System and theSecretary of the Treasury jointly adopton an interim basis, effective March 17,2000, and solicit comment on a rule thatwill govern merchant bankinginvestments made by financial holdingcompanies. This rule implementsprovisions of the recently enactedGramm-Leach-Bliley Act (GLB Act) thatpermit financial holding companies tomake investments as part of a bona fidesecurities underwriting or merchant orinvestment banking activity. A summaryof the rule appears below in theexecutive summary in theSUPPLEMENTARY INFORMATION section.DATES: The interim rule is effective onMarch 17, 2000. Comments must bereceived on both the interim rule andthe capital proposal by May 22, 2000.ADDRESSES: Comments should refer todocket number R–1065 and should besent to Ms. Jennifer J. Johnson,Secretary, Board of Governors of theFederal Reserve System, 20th Street andConstitution Avenue, N.W.,Washington, D.C. 20551 (or mailedelectronically [email protected]) andto Merchant Banking Regulation, Officeof Financial Institution Policy, U.S.Department of the Treasury, 1500Pennsylvania Avenue, N.W., Room SC37, Washington, D.C. 20220 (or mailedelectronically [email protected]).Comments addressed to Ms. Johnsonalso may be delivered to the Board’smail room between the hours of 8:45a.m. and 5:15 p.m. and, outside of thosehours, to the Board’s security controlroom. Both the mail room and thesecurity control room are accessiblefrom the Eccles Building courtyardentrance, located on 20th Street between

Constitution Avenue and C Street, N.W.Members of the public may inspectcomments in Room MP–500 of theMartin Building between 9:00 a.m. and5:00 p.m. on weekdays. Commentsaddressed to the Treasury Departmentmay also be delivered to the TreasuryDepartment mail room between thehours of 8:45 a.m. and 5:15 p.m. at the15th Street entrance to the TreasuryBuilding.

FOR FURTHER INFORMATION CONTACT:Board of Governors: Scott G. Alvarez,

Associate General Counsel (202/452–3583), Kieran J. Fallon, Senior Counsel(202/452–5270), or Camille M. Caesar,Senior Attorney (202/452–3513), LegalDivision; Jean Nellie Liang, Chief,Capital Markets (202/452–2918),Division of Research & Statistics;Michael G. Martinson, Deputy AssociateDirector (202/452–3640) or James A.Embersit, Manager, Capital Markets(202/452–5249), Division of BankingSupervision and Regulation; Board ofGovernors of the Federal ReserveSystem, 20th Street and ConstitutionAvenue, N.W., Washington, D.C. 20551.Users of Telecommunications Device forthe Deaf (TDD) only contact JaniceSimms at (202) 872–4984.

Department of the Treasury: JoanAffleck-Smith, Director, Office ofFinancial Institutions Policy (202/622–2740), Gerry Hughes, Senior FinancialEconomist (202/622–2740); Roberta K.McInerney, Assistant General Counsel(Banking and Finance) (202/622–0480)or Gary Sutton, Senior Banking Counsel(202/622–0480).SUPPLEMENTARY INFORMATION:

A. Executive Summary

This rule implements provisions ofthe recently enacted GLB Act thatpermit financial holding companies tomake investments as part of a bona fidesecurities underwriting or merchant orinvestment banking activity. Theseinvestments may be made in any type ofownership interest in any type ofnonfinancial entity (portfolio company),and may include any amount up to allof the ownership interests in thecompany. The investments that may bemade under this new authority aresubstantially broader in scope than theinvestment activities otherwisepermissible for bank holdingcompanies, and are referred to as‘‘merchant banking investments.’’

The interim rule does not address orapply to securities underwriting,dealing or market making activitiesconducted under section 4(k)(4)(E) ofthe Bank Holding Company Act (BHCAct). Moreover, the authority granted bysection 4(k)(4)(H) of the BHC Act to

financial holding companies to makemerchant banking investments is analternative to any other authority thatthe financial holding company mayhave to make investments innonfinancial companies under otherprovisions of the Bank HoldingCompany Act except as specificallynoted in the rule.

The interim rule sets forth theparameters within which financialholding companies may make merchantbanking investments. As an initialmatter, the GLB Act allows a financialholding company to make merchantbanking investments if the financialholding company controls a securitiesaffiliate or controls both an insuranceunderwriter and a registered investmentadviser. The rule defines a securitiesaffiliate for this purpose to be anyregistered securities broker or dealer.

The GLB Act contains provisions thatare designed to help maintain theseparation between banking andcommerce by limiting the time periodthat a merchant banking investmentmay be held by a financial holdingcompany and the circumstances underwhich the financial holding companymay routinely manage or operate aportfolio company. In particular, theGLB Act provides that merchantbanking investments may be held onlyfor a period of time that enables the saleor disposition of the investment on areasonable basis consistent with thefinancial viability of merchant bankinginvestment activities. The rule providesthat, in most cases, merchant bankinginvestments may be held for a 10-yearperiod. The rule allows a financialholding company to invest in aqualifying private equity fund for theterm of the fund, up to 15 years undercertain circumstances.

With respect to routinely managing oroperating portfolio companies, the ruleclarifies that director interlocks at theportfolio company and certain types ofagreements and covenants that affectonly extraordinary corporate eventswould not, as a general matter, beconsidered routine management oroperation. The rule also provides that afinancial holding company would beconsidered to be routinely managing oroperating a portfolio company if thefinancial holding company establishesinterlocks at the officer or employeelevel of the portfolio company or hascertain other arrangements involvingday-to-day management or participationin ordinary business decisions. The rulesets forth those limited circumstanceswhen it is permissible for a financialholding company to routinely manageor operate a portfolio company, requires


16461Federal Register / Vol. 65, No. 60 / Tuesday, March 28, 2000 / Rules and Regulations

documentation of these interventions,and limits the duration of theinvolvement.

The interim rule contains otherprovisions that are also designed toserve this fundamental purpose ofmaintaining the separation of bankingand commerce as well as to promote thesafe and sound conduct of merchantbanking activities. In particular, the rulerequires financial holding companies toestablish policies and systems tomonitor and assess the various risksassociated with making merchantbanking investments. The financialholding company must also establishpolicies for assuring the corporateseparateness of companies held underthe rule and limiting the potential thatthe financial holding company or itsaffiliated depository institutions may belegally liable for the financialobligations or operations of thosecompanies. In addition, the ruleimplements the cross-marketingprohibitions of the GLB Act and theprovisions of sections 23A and B of theFederal Reserve Act that restricttransactions between a depositoryinstitution and a portfolio companycontrolled by the same financial holdingcompany.

Recordkeeping and reportingrequirements are also established inorder to promote compliance with theprovisions of the rule and the safe andsound conduct of the activity. Theserecords include documentation oftransactions and relationships betweena financial holding company, includingeach of its subsidiaries, and a companyheld under the merchant bankingauthority, with special attention paid totransactions and relationships that arenot on market terms.

Also to limit the potential level of riskto a financial holding company and itsaffiliated depository institutions frommerchant banking investments, theinterim rule establishes aggregateinvestment limits. The new Subpartprovides that a financial holdingcompany may not make additionalmerchant banking investments if theaggregate carrying value of all merchantbanking investments made by thefinancial holding company under theGLB Act exceeds (1) the lesser of 30percent of its Tier 1 capital or $6 billion,or (2) the lesser of 20 percent of Tier 1capital or $4 billion after excludinginvestments made by the financialholding company in private equityfunds. A financial holding companymay invest a greater amount with priorapproval. As explained below, theBoard and the Secretary believe theselimits are necessary until appropriatecapital rules are put in place and

experience is gained in managing andsupervising the risks of this activity.

Chief among the elements necessaryto address safety and soundness is theappropriate capital treatment formerchant banking investments made byfinancial holding companies. The Boardand the Secretary have developed aproposal to address the appropriatecapital charge for merchant bankinginvestments. This proposal seekscomment on an amendment to theBoard’s capital guidelines for bankholding companies that, in general,would apply a 50 percent capital chargeto all merchant banking investmentsmade under the interim rule. Thecapital proposal also requests commenton whether similar capital treatmentshould be applied at the holdingcompany level to investments by bankholding companies and theirsubsidiaries in nonfinancial companiesthrough small business investmentcompanies (whether held directly by thebank holding company or by adepository institution controlled by thebank holding company), underRegulation K, in less than 5% of theshares of companies under section4(c)(6) or 4(c)(7) of the BHC Act, or byan insured state bank subsidiary inaccordance with section 24 of theFederal Deposit Insurance Act (FDI Act).

The interim rule is contained in a newSubpart J to the Board’s Regulation Yand in a new Part 1500 of the rules ofthe Department of the Treasury. Thesenew subparts are promulgated on aninterim basis, effective on March 17,2000, in order to provide guidance tofinancial holding companies regardingthe definitions, limits and supervisoryrequirements that govern the activity ofmaking merchant banking investmentsas soon as possible following theeffective date of the relevant provisionsof the GLB Act.

The capital proposal is describedbelow, and is published separately inaccordance with the requirements of theFederal Register.

The Board and the Secretary of theTreasury solicit comments on all aspectsof the interim rule and will amend therule as appropriate in response tocomments received.

B. Background

Interviews With Securities Firms andBank Holding Companies

In order to gather information abouthow firms currently make merchantbanking investments, staff of the FederalReserve System and the Department ofthe Treasury conducted interviews witha number of securities firms thatcurrently make merchant banking

investments. System staff and Treasurystaff also interviewed several bankholding companies that make morelimited types of investments underexisting authority. The attached rulereflects information collected in theseinterviews and the experience of theSystem in supervising the more limitedtypes of investment activitiespermissible for bank holdingcompanies.

The interviews indicated thatmerchant banking investment activitiesconducted by major securities firmsmost often are conducted throughprivate equity funds, which pool afinancial institution’s capital with fundsfrom third-party investors. Theseinvestors are generally eitherinstitutions (such as other investmentcompanies, pension funds,endowments, charitable organizations,investment units of financialinstitutions, and other companies) orindividuals with high net worth. Thesecurities firm is typically the sponsorand advisor to the fund as well as aninvestor in the fund. The private equityfund may be organized in corporate,partnership or other form, and bycontract has a limited life that typicallyspans 10 years, with the possibility oflimited extensions.

Private equity funds typically havefeatures, including compensationarrangements, that—in addition to thelimited life of the fund—stronglyencourage the resale of investmentsmade by the fund. As a result of theseincentives and structural arrangements,and given current economic conditions,investments made by private equityfunds are typically sold within a periodof between 3 and 5 years. In addition,private equity funds typically havepolicies, review committees or othermeasures that encourage funds todiversify holdings and/or limit theamount of the fund’s capital invested ina single portfolio company.

Securities firms also at times makemerchant banking investments for theaccount of the securities firm and notthrough a private equity fund. Theseinvestments tended to be less significantthan investments made through aprivate equity fund. The investmentperiod for direct investments rangedfrom less than one year to somewhatlonger than 10 years, with investmentsmost often held for an average of 5 yearsunder current conditions.

Securities firms and bank holdingcompanies uniformly indicated thatthey apply higher internal capitalcharges against merchant bankinginvestments than are applied to manyother types of activities. The industrypractice regarding the appropriate



internal measures of capital required tosupport merchant banking activitiesreflects the greater risks associated withthese investments, including thevolatility and illiquidity of manyinvestments, and the fact that portfoliocompanies are themselves oftenleveraged companies. Private equityfunds supported their investmentactivities almost exclusively withcapital contributed by investors.Occasionally, private equity funds relyon short-term leverage that is repaidwith a capital call on investors.However, private equity funds do notappear to rely to any significant extenton debt to fund investment activities.

Firms that make merchant bankinginvestments impose internal capitalcharges that differ by firm and, in somecases, by type of investment. Thesecapital charges range from 25 percent to100 percent of the investment. Firmstypically record investments initially atthe lower of cost or market. Investmentsmay be assigned an adjusted carryingvalue if a significant event occurs (suchas an initial public offering, follow-upfinancing, or secondary capital raisingevents), subject to a discount thatreflects the size of the firm’s holding,the liquidity of the market for the sharesheld, the volatility of the market andother factors and that is applied prior torecognizing any unrealized gains on theinvestment. The securities firms all havepolicies for reviewing and recording thevalue of individual investments and theappropriate discounts to apply to theunrealized gains on investments.

Securities firms use a variety ofmethods to monitor the condition ofportfolio companies. The mostimportant involve receiving formal andinformal reports on both a periodic basisand in the case of significant events, andmaintaining representation on the boardof directors of the portfolio company.Securities firms typically participate tothe fullest extent allowed under theirownership interest in selecting theboard of directors of a portfoliocompany and often select officers andemployees of the firm to serve on theboard of the portfolio company. Thesedirectors exercise the full rights andresponsibilities of a member of theboard, but are not expected to becomeinvolved in the routine management oroperation of a portfolio company, as ageneral matter.

In both the private equity fundcontext and the direct investmentcontext, securities firms indicated thatthe firm would on occasion becomeinvolved in routinely managing oroperating a portfolio company. Theseinterventions occur in limited situationswhen the merchant banker determines

that intervention is necessary (1) torespond to an unusual event thatdirectly affects the value of theinvestment, such as loss of portfoliocompany senior management,operational failures, major acquisitions,business plan changes and significantbusiness losses, or (2) to facilitate thesale or disposition of the investment,such as participation in negotiations forsale of the portfolio company or theinitial public offering of the company’sshares. These interventions aretemporary in most cases and usuallytake the form of increased consultationwith the management of the portfoliocompany, exercise of review and vetorights over certain extraordinarydecisions of management, replacementof management, and, in a small numberof cases, temporary appointment of arepresentative of the investor as anofficer of the portfolio company.

C. Interim RuleThe GLB Act specifically provides

that the Board and the Secretary of theTreasury may issue regulationsimplementing section 4(k)(4)(H) thatthey jointly determine to be appropriateto assure compliance with the purposesand prevent evasions of the BHC Actand the GLB Act and to protectdepository institutions, includinglimiting transactions betweendepository institutions and companiescontrolled under section 4(k)(4)(H) (12U.S.C. 1843(k)(7)(A)) and reporting andrecordkeeping requirements. The Boardis also authorized by the BHC Act andother provisions of law to promulgaterules, including capital standards andreporting and recordkeepingrequirements, consistent with therequirements and purposes of the BHCAct and other provisions.

The proposed interim rule reflects theinformation collected in the interviewprocess in defining the parameters ofmerchant banking activities, allowableholding periods, involvement in themanagement and operation of portfoliocompanies and the monitoring and riskmanagement systems these firms havedeveloped. As noted above, securitiesfirms and others that make merchantbanking investments recognized thatmerchant banking investments are oftenriskier, less liquid and more volatilethan many other types of investmentsand often involve an investment in aleveraged company. Consequently, theseinvestments require greater capitalsupport, careful monitoring andvaluation systems, specific policies foraddressing diversification ofinvestments, and carefully developedlimits on the amount of funds put at riskin the activity. In each of these areas,

the interim rule and proposal areconsistent with industry practices inmaking, monitoring and managing therisks associated with merchant bankinginvestments.

At the same time, the Board and theSecretary recognize that, by its nature,an agency rule sets outside limits, andin several key areas—such as theduration of holding periods, internalcapital charges, and level ofinvolvement in management of portfoliocompanies—industry practice has beenmore conservative than—and wellwithin—the outside parameters set bythe rule and proposal. In setting outsidelimits, the Board and the Secretary donot intend to encourage behavior that isdifferent than more conservativeindustry practice and expect to monitormerchant banking activities carefullyand discourage migration from thenorms for conducting these activities tothe outer limits allowed under the ruleand proposal.

While the rule is being adopted on aninterim basis, the Board and theSecretary welcome comments on allaspects of the interim rule. Thesecomments will be carefully consideredand adjustments made to the interimrule as appropriate before its finaladoption.

Section 225.170—What Investments ArePermitted Under This Subpart and WhoMay Make Them?

As noted above, section 4(k)(4)(H) andthe interim rule permit a financialholding company to acquire or controlshares, assets or ownership interests ofany company that engages in activitiesthat are not otherwise permissible for afinancial holding company. Interestsacquired or controlled under the interimrule are referred to as merchant bankinginvestments, and a financial holdingcompany must comply with therequirements of this interim rule inorder to make such investments.

A financial holding company is notrequired to obtain the Board’s approvalor provide notice to the Board before thefinancial holding company beginsmaking merchant banking investmentsor acquires a company that makesmerchant banking investments. Afinancial holding company must,however, file notice with the Boardunder section 4(k)(6) of the BHC Actand section 225.87 of Regulation Y (12CFR 225.87) within 30 days aftercommencing merchant bankinginvestment activities or acquiring anycompany that makes merchant bankinginvestments.

Section 4(k)(4)(H) provides that afinancial holding company may acquireor control shares of a company under



1 For purposes of determining whether aninvestment qualifies under the alternative authorityfor making investments granted by Regulation Kand by sections 4(c)(6) and (7) of the BHC Act, afinancial holding company must generally aggregateall investments held by the financial holdingcompany in a single company.

2 A subsidiary of a member bank may makemerchant banking investments only if, after fiveyears, the Board and the Secretary jointly adoptrules in accordance with section 122 of the GLB Actthat permit financial subsidiaries of member banksto make merchant banking investments.

3 The Board recently adopted, on an interim basis,regulations governing the process by which a bankholding company may become a financial holdingcompany. See 65 FR 3785 (January 25, 2000).

4 Nothing in the merchant banking provisionoverrides the prior approval requirements of section3 of the BHC Act that govern the acquisition ofshares of a bank or bank holding company or theprovisions of section 4(k)(6) and 4(j) of the BHC Actthat govern the acquisition of shares of a savingsassociation.

that section ‘‘as part of a bona fideunderwriting or merchant or investmentbanking activity.’’ The Board and theSecretary wish to emphasize theimportance of this requirement inpreventing circumvention of one of thefundamental purposes of the GLB Act ofmaintaining the separation of bankingand commerce.

This requirement prevents themerchant banking authority from beingused to engage in a nonfinancialactivity. It distinguishes authorizedmerchant banking investments fromstrategic or other types of investmentsthat are not permitted under the BHCAct or the GLB Act, such as thepurchase of a commercial company or areal estate project made for the purposesof engaging in a commercial or othernonfinancial activity. Thus, forexample, this authority could not beused by the financial holding companyto engage in real estate development orother activities that have not been foundto be financial.

This ‘‘bona fide’’ requirement doesnot prevent the acquisition of an interestin a company engaged in real estatedevelopment as part of a diversifiedportfolio of investments by the financialholding company in connection with itsmerchant banking business and inaccordance with the other restrictions inthe interim rule. The Board and theSecretary recognize that investments inreal estate are often part of a diversifiedmerchant banking portfolio. The Boardand the Secretary believe, however, thatthe subpart would not allow a financialholding company to acquire a real estatedevelopment company if thatacquisition represented all orsubstantially all of the holdingcompany’s investments claimed underthis subpart. The rule includes this‘‘bona fide’’ provision, and the Boardwill carefully monitor merchant bankinginvestments to ensure that they meetthis requirement and that the merchantbanking authorization is not used by afinancial holding company to engage inimpermissible nonfinancial activities.

Under the statute and the rule,merchant banking investments includethe full range of ownership interests,including securities, warrants,partnership interests, trust certificates,and other instruments representing anownership interest in a company,whether the interest is voting ornonvoting. They also include anyinstrument convertible into a security orother ownership interest.

Under the statute and the rule,merchant banking investments mayrepresent any amount of ownershipinterests in a portfolio company,whether or not that amount results in

control for purposes of the BHC Act.Thus, this authority allows a financialholding company the flexibility to useits merchant banking authority toacquire or control a nominal amount ofshares of a portfolio company or all ofthe ownership interests in a portfoliocompany.

The authority granted by section4(k)(4)(H) is an alternative to the otherauthority granted to financial holdingcompanies to make investments innonfinancial companies under otherprovisions of the BHC Act.1 Moreover,the rule does not address or apply tosecurities underwriting, dealing ormarket-making activities conductedunder section 4(k)(4)(E) of the BHC Act.

The rule allows financial holdingcompanies to make investments directlyor through any subsidiary other than adepository institution or subsidiary of adepository institution.2 The rule alsoincorporates the provision of the GLBAct that prohibits a financial holdingcompany from making merchantbanking investments on behalf of adepository institution or subsidiary of adepository institution. For purposes ofthe provisions of the rule, the term‘‘financial holding company’’ refers tothe financial holding company and anydirect or indirect subsidiary of theholding company other than a portfoliocompany. The term ‘‘financial holdingcompany’’ does not include a depositoryinstitution controlled by the financialholding company or any subsidiary ofsuch a depository institution, except forpurposes of the routine managementprovisions of section 171 and therecordkeeping and reporting provisionsof section 174.

Subsection (e) allows a financialholding company to acquire and hold‘‘assets’’ (other than shares or otherownership interests) of a company. Inkeeping with the stricture in section4(k)(4)(H) that assets be ‘‘of a company,’’subsection (e) requires that assetsacquired as a merchant bankinginvestment, such as real estate or assetsof a division of an operating company,be promptly placed in and held througha portfolio company that maintainsstrict corporate separation from thefinancial holding company in order to

limit the liability of the financialholding company and its financial anddepository institution affiliates for thefinancial obligations and operating risksof the asset.

To take advantage of this newauthority, section 4(k)(4)(H) of the BHCAct requires that a bank holdingcompany become a financial holdingcompany.3 In addition, the financialholding company must control either (1)a securities affiliate or (2) both aninsurance underwriter and aninvestment adviser, registered under theInvestment Advisers Act of 1940, thatprovides investment advice to aninsurance company. Subsection (f)incorporates this requirement.

Subsection (f) also defines a‘‘securities affiliate’’ to include anybroker or dealer registered with theSecurities and Exchange Commission.The adoption of this definition wouldallow a broader range of financialholding companies to make merchantbanking investments than a definitionrestricted to securities underwritingfirms.

The Board and the Secretary requestcomment on whether this or anotherdefinition is appropriate. In particular,the Board and the Secretary requestcomment on whether ‘‘securitiesaffiliate’’ should include a division of abank that is registered as a municipalsecurities dealer. In this regard, theBoard and Secretary seek comment onwhether expertise or policies developedin the course of conducting specifictypes of securities activities may benecessary or appropriate for makingmerchant banking investments in a safeand sound manner.

As noted above, the rule adopts thelanguage of section 4(k)(4)(H) of theBHC Act that allows investments in anycompany ‘‘engaged in any activity notauthorized pursuant to [section 4 of theBank Holding Company Act],’’ that is,any company engaged in an activity thatis not financial in nature or incidentalto a financial activity or otherwisepermissible for a financial holdingcompany to conduct.4 This provisionappears to have been included inrecognition of the fact that otherprovisions of the BHC Act permit afinancial holding company to makeinvestments in companies that conduct



financial activities without resorting tomerchant banking authority.

This distinction, however, may havepractical consequences for privateequity funds. As a result of thisdistinction in the statute and otherprovisions of the GLB Act, a privateequity fund controlled by a financialholding company would appear to beprohibited from acquiring anyadditional financial company if anyinsured depository institutioncontrolled by the financial holdingcompany fails to have at least asatisfactory CRA rating, or, potentially,does not remain well managed and wellcapitalized. The Board and the Secretaryrequest comment on this and on what,if any, amendments to the rule would beappropriate to deal with suchaffiliations within the requirements ofthe GLB Act.

Section 225.171—What Are theLimitations on Managing or Operating aPortfolio Company Held as a MerchantBanking Investment?

A financial holding company isprohibited by the GLB Act fromroutinely managing or operating aportfolio company except as may benecessary or required to obtain areasonable return on the resale ordisposition of the investment. Section225.171 provides guidance on thisstatutory restriction.

Under this section, a financial holdingcompany is considered to be engaged inroutinely managing or operating aportfolio company if any director,officer, employee or agent of thefinancial holding company serves as orhas responsibilities of an officer oremployee of the portfolio company. TheBoard and the Secretary seek commenton whether any such interlocks wouldbe appropriate.

Similarly, routinely managing oroperating a company would includesupervising any officer or employee ofthe portfolio company, other thanthrough participation on the board ofdirectors. The rule also definesroutinely managing or operating acompany to include any covenant orother contractual arrangement betweenthe financial holding company and theportfolio company that would restrictthe portfolio company’s ability to makeroutine business decisions, such asentering into transactions in theordinary course of business or hiringemployees below the rank of the fivemost senior officers.

In addition, the rule defines routinelymanaging or operating a company toinclude participation in the day-to-dayoperations of the portfolio company. Italso includes participation in

management decisions made in theordinary course of business of theportfolio company (other than decisionsin which directors of a companycustomarily participate in their capacityas a director).

A financial holding company is notconsidered to be engaged in routinelymanaging or operating a portfoliocompany by virtue of having one ormore representatives on the board ofdirectors of the portfolio company. Forthis purpose, the Board’s existinginterpretations consider selection of ageneral partner to be the equivalent ofselecting the board of directors. Arepresentative of the financial holdingcompany that serves as a director of aportfolio company may not routinelymanage or operate the portfoliocompany, as discussed more fullyabove. In addition, in order for thefinancial holding company to have adirector interlock without beingconsidered to be routinely managing oroperating a portfolio company, theportfolio company must employ officersand employees responsible formanaging and operating the company,and no other arrangements or practicesmay exist that constitute routinemanagement or operation of theportfolio company by the financialholding company.

The rule anticipates thatrepresentatives of the financial holdingcompany will participate fully inmatters typically presented to directorsto the same degree as any other director.This permits the current practice ofmerchant bankers of placingrepresentatives on the board of directorsof a portfolio company in order tomonitor the success of the company andassist at the board of directors level inoverseeing and providing strategicadvice to the management of theportfolio company. At the same time,the rule is intended to define as routinemanagement or operation situations inwhich a representative of the financialholding company takes onresponsibilities or is involved indecisions that are typically made byofficers or employees of a portfoliocompany and not customarilyconsidered by directors.

The section identifies a set ofcovenants and other written agreementsbetween a financial holding companyand a portfolio company, that, in theabsence of circumstances that wouldindicate otherwise, are not consideredto represent routinely managing oroperating a portfolio company. Theseagreements and covenants may requirethe portfolio company to seek theapproval of, or to consult with, thefinancial holding company before taking

actions outside of the ordinary course ofbusiness, including (i) the acquisition ofassets of another company; (ii)significant revision of the business plan;(iii) redemption, authorization orissuance of any shares of capital stock(including options, warrants orconvertible shares) by the portfoliocompany; and (iv) the sale, merger,consolidation, spin-off, recapitalization,liquidation or dissolution of theportfolio company or any of itssignificant subsidiaries, or of all orsubstantially all of the assets of suchcompany or subsidiary.

Under the Act and the rule, afinancial holding company mayroutinely manage or operate a portfoliocompany under limited circumstances.The rule provides that this type ofintervention is permitted only whennecessary to address a material risk tothe value or operation of the portfoliocompany. This might include asignificant operating loss or a loss ofsenior management. This involvementmust be temporary, and last only for thetime necessary for the financial holdingcompany to address the cause ofinvolvement, obtain suitable alternativemanagement arrangements, dispose ofthe investment or otherwise obtain areasonable return on the investment.The rule would require a financialholding company to obtain Boardapproval to routinely manage or operatea portfolio company for a period greaterthan six months, and requires that afinancial holding company documenteach instance of its involvement inroutinely managing or operating aportfolio company.

The rule provides that a depositoryinstitution or subsidiary (other than afinancial subsidiary held in accordancewith section 5136A of the RevisedStatutes or section 46 of the FederalDeposit Insurance Act) of a depositoryinstitution may not under anycircumstances manage or operate acompany held under this rule. Thislimitation would also apply to U.S.branches and agencies of foreign banks.The rule would, however, allow adirector, officer or employee of adepository institution (or subsidiary of adepository institution) or U.S. branch oragency to serve as a director of aportfolio company to the same extent aswould be permitted for a representativeof a financial holding company.

As explained more fully below, therule permits merchant bankinginvestments to be made through so-called private equity funds that aresubject to several limits different thanthose that apply to other merchantbanking investments. The rulecontemplates that a financial holding



company may control and manage aprivate equity fund or may be a passiveinvestor in the fund. The restrictions onroutinely managing or operatingportfolio companies acquired orcontrolled by the private equity fundapply to both the financial holdingcompany and the private equity fund.

The Board and the Secretary requestcomment on each of these provisions. Inparticular, comment is requested onwhether there are additional situationsin which a financial holding companyshould be permitted routinely tomanage or operate a portfolio companyconsistent with the statute and itspurpose of preventing the mixing ofbanking and commerce. Comment isalso sought on whether additionalagreements and covenants should beincluded in the list of arrangements thatwould not represent routinemanagement or operation of theportfolio company.

Section 225.172—What Are the HoldingPeriods Permitted for Merchant BankingInvestments?

The GLB Act requires that shares,assets and ownership interests be heldonly for a period of time that enables thesale or disposition of the interest on areasonable basis consistent with thefinancial viability of the merchantbanking activity. The rule incorporatesthis statutory limitation.

Consistent with industry practice, therule generally would allow merchantbanking investments to be held for aperiod of up to 10 years. Interests heldby a financial holding company inprivate equity funds (defined below)could be held for the life of the fund, upto 15 years under circumstancesdescribed below.

The rule allows a greater period forholding merchant banking investments,including investments in or by privateequity funds, in exceptionalcircumstances, with Board approval. Toreceive that approval, the financialholding company must explain thefinancial holding company’s plan fordivesting the investment. Indetermining whether to grant theextension, the Board may consider thecost to the financial holding company ofdisposing of the investment within theapplicable time period. The Board mayalso consider the total exposure of thefinancial holding company to theportfolio company and the risks thatdisposing of the investment without anextension may pose to the financialholding company. In addition, theBoard may consider market conditionsand any other relevant information,such as the financial holding company’shistory of timely disposition of

investments. The rule provides that arequest for additional time must be filedat least 1 year prior to the expiration ofthe normal holding period.

The rule also establishes severalsupervisory restrictions designed todiscourage investments from being heldbeyond the applicable period describedabove (i.e., 10 years in general, and upto 15 years under certain circumstancesfor investments made in a private equityfund). First, the rule requires a financialholding company that has held, owned,or controlled a merchant bankinginvestment for longer than theapplicable period to deduct 100 percentof the carrying value of its investmentfrom the holding company’s Tier 1capital and does not allow the financialholding company to include any of theunrealized gains on the investment inits Tier 2 capital for regulatorypurposes. The financial holdingcompany is also prohibited fromentering into any additional contractualarrangements or other relationshipswith the company or extending anyadditional credit to the companywithout Board approval. Theserequirements would apply in additionto any restrictions that the Board mightimpose in granting approval for anextended holding period.

As noted above, the rule establishessomewhat different holding periods forinvestments made in private equityfunds. The rule defines a ‘‘private equityfund’’ based on prevalent industrypractice. A qualifying private equityfund is defined as any company that isnot an operating company and thatengages exclusively in merchantbanking activities. The fund may beorganized in any form, including apartnership, corporation or limitedliability company. The fund may, butneed not be, registered as an investmentcompany under the Federal securitieslaws.

To meet the rule’s definition, a privateequity fund must be owned by at least10 investors that are unrelated to thefinancial holding company (and are notofficers, directors, employees orprincipal shareholders of the financialholding company) and the financialholding company (including its officers,directors, employees and principalshareholders) may not own or controlmore than 25 percent of the equitycapital of the fund. The rule does notimpose any limits on advisory fees or onthe various types of incentivecompensation that the financial holdingcompany may receive for servicesrendered to the fund (except to theextent the fee increases the equitycapital owned or controlled by the

financial holding company above the 25percent threshold described above).

To qualify, a fund must invest inshares, assets or ownership interests ofcompanies for the purpose of resellingor disposing of them and must establisha plan for the resale or disposition of itsinvestments. In addition, the fund musthave a limited life that does not exceed12 years, with the possibility of three 1-year extensions with the approval ofpersons holding a majority of the fund’sequity. The rule does not, however,impose the 10-year holding period onportfolio companies held by privateequity funds.

A fund cannot ‘‘routinely manage oroperate’’ the portfolio companies inwhich it invests except in the situationsidentified in section 225.171. A fund isalso expected to have policies to addressdiversification of its portfolio, whichmay include single investment limits,review of large investments by investorsother than the adviser, or otherapproaches. Finally, the fund must notbe established or operated to evade thelimitations on merchant bankingactivities contained in the GLB Act orthe rule.

A financial holding company may,without Board approval, own or controla private equity fund that meets theserequirements for the term of the fund upto 12 years, plus three additional one-year increments that may be obtainedwith the approval of a majority of theinvestors in the fund. In addition,different aggregate limits, reportingrequirements and recordkeepingrequirements apply to private equityfunds and interests held by a financialholding company in private equityfunds.

Moreover, as explained more fullybelow, the restrictions on cross-marketing, the limitations of sections23A and 23B of the Federal Reserve Act,and the reporting and recordkeepingrequirements of the rule, do not applyto a financial holding company thatholds a passive interest in a privateequity fund that is controlled orsponsored and advised by an unrelatedthird party. These requirements,however, would apply to a financialholding company that controls theprivate equity fund.

These differences recognize thatprivate equity funds typically areestablished for the purpose of makinginvestments for resale and have alimited term and a number of otherincentives and terms that encourage theresale or disposition of investmentswithin a reasonable period. Importantly,investments made by private equityfunds also are monitored by outside



investors that encourage resale ofinvestments.

A financial holding company mayalso own an interest in or control aninvestment vehicle or fund that makesmerchant banking investments but thatdoes not meet the rule’s definition of aprivate equity fund. If a financialholding company controls theinvestment vehicle or fund, theninvestments made by the investmentvehicle or fund are subject to the 10-year holding period and the otherprovisions of the rule governingownership or control of a portfoliocompany. If a financial holdingcompany owns an interest in, withoutcontrolling, such an investment vehicleor fund, the interest is treated as aninterest in a portfolio company forpurposes of the rule.

The rule also contains a provision thatprevents a financial holding companyfrom attempting to circumvent theholding periods by transferringmerchant banking investments from onecompany or fund to another. The rulealso provides that, for purposes ofcalculating compliance with themerchant banking holding periods, aninvestment acquired by the financialholding company under anotherauthority that imposes a restriction onthe amount of time that the financialholding company may hold theinvestment is considered to have beenacquired on the original acquisitiondate.

The Board and the Secretary requestcomment on whether the approachtaken in the rule is appropriate orwhether more specific limits oninvestments should be adopted. TheBoard and the Secretary also requestcomment on whether additionalincentives are necessary or appropriateto assure that merchant bankinginvestments are held only for areasonable period consistent with thefinancial viability of the activity.

The Board and the Secretary alsorequest comment on whether it isappropriate or useful to establishdifferent rules for holding periods andother requirements for merchantbanking investments made in andthrough private equity funds than thosemade by a financial holding companydirectly or otherwise. If it is appropriateand helpful, comment is invited onwhether the proposed rule properlydefines private equity funds andwhether the limits contained in the ruleare consistent with the requirementsand purposes of the GLB Act and theBHC Act.

Section 225.173—What AggregateLimits Apply to Merchant BankingInvestments?

The authority to make merchantbanking investments is newly granted tothose bank holding companies that havebeen certified as financial holdingcompanies. As noted above, thisauthority is in addition to otherauthority provided to all bank holdingcompanies (including financial holdingcompanies) under the BHC Act to makeinvestments. These existing authoritiesallow investments in nonfinancialcompanies to be made through smallbusiness investment companies, outsidethe United States under Regulation K,and in up to 5 percent of the votingshares of any company. In addition, afinancial holding company may makeinvestments under the GLB Act throughinsurance underwriting companies.

The Board and the Secretary areconcerned that rapid expansion ofmerchant banking activities, particularlygiven the flexibility provided for suchinvestments under the GLB Act, maypose new and potentially significantrisks to the safety and soundness ofdepository institutions affiliated withfinancial holding companies engaged inthese activities. These risks seemparticularly apparent and material if thefinancial holding company commits asignificant portion of its capital tomerchant banking investments withoutappropriate systems for monitoring andmanaging the risks of these activities, orif the financial holding company doesnot reserve sufficient capital to takeaccount of the risks of theseinvestments.

Accordingly, until such time as theagencies and the industry have gainedexperience with supervising theseactivities and the rules governing theregulatory capital treatment of theseinvestments are in place, the ruleestablishes two aggregate limits onmerchant banking investments. The firstthreshold prevents a financial holdingcompany from making additionalmerchant banking investments(including making additional capitalcontributions to a company held underthe rule) if the aggregate carrying valueto the financial holding company of allits merchant banking investmentsexceeds the lesser of 30 percent of thefinancial holding company’s Tier 1capital or $6 billion. A second sublimitapplies to the aggregate carrying valueof all merchant banking investmentsexcluding investments made by thefinancial holding company in privateequity funds. This sublimit is the lesserof 20 percent of the financial holdingcompany’s Tier 1 capital or $4 billion.

The rule provides that a financialholding company may exceed eitherthreshold with the prior approval of theBoard. This gives the Board flexibility todeal with circumstances that may arisebefore final action in this area on theBoard’s capital proposal.

In establishing these limits, the Boardand the Secretary have considered thatmany securities firms that makemerchant banking investments andmany bank holding companies thatconduct more limited investmentactivities already impose internal limitson the aggregate amount of capital thatthey will commit to these investments.The Board and the Secretary have alsoconsidered the current levels ofinvestment activities of bank holdingcompanies under existing authority.Neither threshold contained in theinterim rule would apply to the existingactivities of bank holding companies (orfinancial holding companies) conductedunder other authority, such as authorityto own a small business investmentcompany, authority to makeinvestments abroad under Regulation K,or authority to acquire 5 percent or lessof the voting shares of any company.

The Board and the Secretary requestcomment on whether these thresholdsare appropriate, and, if the thresholdsare retained, whether they should beincreased or decreased, whether themechanism for Board approval toexceed the thresholds should beretained, and whether the thresholdsshould be based on the initial cost ofinvestments or the carrying value ofinvestments. The Board and theSecretary also request comment onwhether the limits on merchant bankinginvestments should be structured to takeaccount of the types and levels of otherkinds of investments made by financialholding companies. In particular,should a higher limit be set for financialholding companies that do not havesignificant investments under otherauthorities.

The Board and the Secretary expect torevisit these limits in connection withconsideration of the final capital rulesfor this activity and as the agencies andthe industry gain experience inconducting and supervising merchantbanking activities and in implementingthe proposed capital rules forinvestment activities.

Section 225.174—What RiskManagement, Reporting and RecordKeeping Policies Are Required To MakeMerchant Banking Investments?

This section requires financialholding companies to adopt policies,procedures and systems reasonablydesigned to manage the risks associated



with making merchant bankinginvestments. It also requires policiesand systems designed to monitorcompliance with the statutory andregulatory provisions governing theseactivities. A financial holding companythat controls a private equity fund orother company that makes investmentsunder the interim rule is expected toestablish the same types of systems andpolicies for monitoring and managingthe risks of merchant bankinginvestments acquired or controlled bythe private equity fund or company asthose required for other types ofmerchant banking investments.

The list of policies, procedures andsystems contained in the interim rule, aswell as the recordkeeping requirements,are not intended to be exclusive.Instead, these lists are representative ofthe types of policies, procedures andsystems that are important elements ofa sound approach to monitoringmerchant banking investment activities,and others will be needed to address theparticular approach that each financialholding company takes to makingmerchant banking investments. Beyondthe procedures and systems required bythe rule, it is essential to prudently andprofitably making merchant bankinginvestments that a financial holdingcompany retain qualified personnel andcarefully manage and overseeinvestment decisions.

Each financial holding company isexpected to institute appropriatepolicies and systems to monitor andmanage investment activities before thecompany commences the activity. TheBoard expects to conduct a review of thepolicies and systems, in particular theinvestment and risk managementsystems, of each financial holdingcompany that makes merchant bankinginvestments within a short period afterthe holding company commences theactivity.

Among the policies and systems thata financial holding company is expectedto establish are policies and systemsdesigned to identify and assessadequately the value of individualinvestments and of the aggregateportfolio. These systems must alsoadequately assess the total exposure ofthe financial holding company to eachcompany acquired under the rule, andthe diversification of the portfolio. Afinancial holding company must be ableto identify and manage the market,liquidity, credit and other risksassociated with merchant bankinginvestments and the terms, amounts andtypes of transactions between thefinancial holding company (and each ofits subsidiaries) and each companyacquired under the rule.

In addition, the policies and systemsmust be adequate to maintain corporateseparateness between the financialholding company and each portfoliocompany and sufficient to protect thefinancial holding company from legalliability for the conduct of operationsand for the financial obligations ofportfolio companies. The financialholding company must also developpolicies and a business structure to limitthe legal liability of the financialholding company for the financialobligations and operating risks that mayflow through a private equity fundcontrolled by the financial holdingcompany. This may include establishinga corporation or limited liabilitycompany that would be the generalpartner of a private equity fundcontrolled by the financial holdingcompany.

Moreover, these systems and policiesmust be adequate for ensuringcompliance with the statutory andregulatory provisions governingmerchant banking activities, includingthe limits on holding period, routinelymanaging or operating a portfoliocompany, and the cross-marketing andinter-company transaction limitsimposed under other provisions of theGLB Act or other law.

Subsection (b) requires generally thata financial holding company maintain ata central location certain types ofrecords and supporting information.This section contemplates that financialholding companies will be able tosatisfy these record keepingrequirements by using reports andrecords that are prepared in the ordinarycourse of making a merchant bankinginvestment or controlling a privateequity fund and used to inform third-party investors of the type and status ofmerchant banking investments.

In particular, these records andmaterials must document the company’spolicies for making merchant bankinginvestments and for managing andmonitoring the various risks andexposures created by these activities.These records would include, forexample, documentation of the reviewprocess for making investments and forproperly assessing the value of eachinvestment. In addition, these recordsmust detail the investment amount,carrying value, market value,performance data and financialstatements for each merchant bankinginvestment.

These records must also includerecords of transactions between thefinancial holding company andcompanies held under the rule. Inparticular, these records must document

transactions that are not on marketterms.

The financial holding company wouldbe expected to make available anyreports, including valuations ofinvestments, given to co-investors bythe financial holding company or givento other investors in a private equityfund. The financial holding company isalso expected to document incentivearrangements (sometimes calledoverrides or carried interests) inconnection with advising or controllinga fund under this rule, including thecarrying value and market value of thearrangement and amounts distributedunder the arrangement that may becontingent on future asset performance.

Subsection (c) establishes annual andquarterly reporting requirementsregarding merchant bankinginvestments. The annual report focuseson investments that have been held fora period longer than five years. Aprivate equity fund controlled by afinancial holding company is onlyrequired to provide annual reportsregarding investments that have beenheld by the fund for a period longerthan eight years. A financial holdingcompany that has made a passive non-controlling investment in a privateequity fund is only required to report itsinvestment in the fund as part of anannual report after eight years and is notrequired to report investments held bythe fund.

The annual report must list anddescribe each investment held for theapplicable period (i.e., longer than eightyears in the case of private equity fundsand longer than five years in all othercases) as of the date of the report. Inaddition, the report must brieflydescribe the historical cost of theinvestment, the market valuation of theinvestment as of the reporting date, andthe schedule for divestiture of theinvestment. A financial holdingcompany that does not sell or dispose ofan investment within eight years(including in the case of private equityfunds) must include in its annual reporta detailed divestiture plan for theinvestment.

The annual report must also includeaggregate data regarding the merchantbanking investments made by thefinancial holding company broadlydivided by category. These categorieswould be divided by general industrialsector, geography (national,international or regional as appropriate),and holding periods.

The quarterly report focuses entirelyon aggregate data regarding the financialholding company’s merchant bankingportfolio. The report would requirequarterly reporting of the total number



5 A financial subsidiary may engage in many ofthe activities permissible for a financial holdingcompany, but may not engage in merchant bankingactivities, certain insurance underwriting activities,or real estate investment or development activities.

of investments made under themerchant banking authority, theaggregate cost of these investments, andthe current valuation of the merchantbanking portfolio (including any valueassigned to any incentive arrangementsrelated to a private equity fund). Theseaggregates would be reported for severalcategories of investment, such asinvestments made in private equityfunds, investments made in publiclytraded securities, and investments madein ownership interests that are notpublicly traded.

The Board expects shortly to issueforms that may be used to comply withthe annual and quarterly reportingrequirements.

Section 4(k)(6) of the BHC Actrequires a financial holding company toprovide written notice to the Boardwithin 30 days after acquiring anycompany under any authority granted insection 4(k). Merchant bankinginvestments, by their nature, must betemporary and held for resale.Consequently, the Board believes thatthe filing of notice in connection withthe acquisition of a company done inthe course of conducting merchantbanking activities is generally notneeded, except in the context of largeinvestments. Notice of substantialinvestments made under the merchantbanking authority would allow theBoard to monitor financial holdingcompanies that have large exposures tosingle portfolio companies.

On this basis, the rule provides thata financial holding company will fulfillthe notice requirements of section4(k)(6) of the BHC Act in connectionwith its merchant banking activities ifthe company files a notice with theBoard within 30 days of making anacquisition of a company under the ruleonly in the situation where both: (1) Theacquisition represents in excess of 5percent of the voting shares, assets orownership interests of the company and(2) the cost of the investment exceedsthe lesser of 5 percent of the Tier 1capital of the financial holding companyor $200 million. This notice must brieflyindicate the cost and funding of theinvestment, the percentage of regulatorycapital that the investment represents,the nature of the company acquired andthe type of investment, and the riskmanagement measures that apply to thisinvestment. A financial holdingcompany qualifies for this streamlinednotice procedure only if the financialholding company has notified the Boardunder section 225.87 of Regulation Ythat the financial holding company hascommenced or acquired a companyengaged in making merchant bankinginvestments.

Comment is invited on each of therecordkeeping and reportingrequirements. In particular, comment issought on whether the requestedinformation would be readily availableand valuable if provided in either aquarterly or annual report, and on theburdens associated with the proposedreporting requirements. Comment isalso requested on whether it isappropriate to provide differentreporting requirements for investmentsmade by and in private equity fundsthan other types of merchant bankinginvestments.

Section 225.175—How do the StatutoryCross-Marketing and Section 23A and BLimitations Apply to Merchant BankingInvestments?

The GLB Act prohibits depositoryinstitutions controlled by the financialholding company from marketing oroffering, directly or through anyarrangement, any product or service ofa company held under the rule orallowing any product or service of thedepository institution to be offered ormarketed, directly or through anyarrangement, by or through anycompany held under section 4(k)(4)(H).Section 225.175 of the interim ruleimplements this prohibition. Inaddition, this section includes thestatutory presumption regarding controlby a financial holding company of acompany held under section 4(k)(4)(H)for the purposes of sections 23A and23B of the Federal Reserve Act.

Subsection (a) addresses theprohibition on cross-marketing. Thecross-marketing restrictions wouldapply to cross-marketing between adepository institution controlled by afinancial holding company and anyportfolio company, private equity fundor other investment vehicle in whichthe financial holding company has aninterest under this subpart. Therestrictions would not apply to cross-marketing with a portfolio company thatis owned by a private equity fund orother investment vehicle, however,unless the financial holding companycontrols the private equity fund orinvestment vehicle. Where controlexists, the financial holding company isdeemed by the BHC Act to indirectlyown the shares of the portfolio companyheld by the private equity fund orinvestment vehicle.

The restrictions on cross-marketingare applied to the U.S. branches andagencies of foreign banks that conductmerchant banking activities in theUnited States or through a U.S.company. The cross-marketingrestrictions also apply to any subsidiaryof a depository institution, other than a

financial subsidiary held in accordancewith section 5136A of the RevisedStatutes or section 46 of the FederalDeposit Insurance Act.5 These so-calledoperating subsidiaries are considered tobe and are authorized as a part of thedepository institution.

Neither the GLB Act nor the ruleapplies these restrictions to cross-marketing by nondepository affiliates ofthe financial holding company.Moreover, the rule does not apply theserestrictions to companies in which thefinancial holding company, eitherdirectly or through a private equity fundor other investment vehicle, owns lessthan 5 percent of the voting shares.

The rule does not define cross-marketing activities. Cross-marketingwould not appear to cover efforts by adepository institution to syndicate aloan made to a portfolio company, thepurchase by a depository institution forits own use of products or services of aportfolio company, or the provision ofservices or extensions of credit by thedepository institution directly to theportfolio company. These latter twotypes of transactions would, of course,be governed by the requirements ofsections 23A and 23B if the portfoliocompany is an affiliate of the depositoryinstitution.

The Board and the Secretary requestcomment on whether it would be usefulto include a definition of cross-marketing activities in the rule, and ifso, invite comment on an appropriatedefinition. The Board and the Secretaryalso seek comment on the scope of thecross-marketing restrictions. Inparticular, comment is invited onwhether these restrictions should beapplied more broadly than in theinterim rule or whether the statutepermits a more limited application.

Subsection (b) establishes a rebuttablepresumption of control for purposes ofthe restrictions contained in section 23Aand 23B of the Federal Reserve Act ontransactions between an insureddepository institution and its affiliates.Under sections 23A and 23B, certaintypes of transactions between aninsured depository institution and anaffiliate are subject to specificquantitative, qualitative and collateralrequirements.

Under the presumption contained inthe GLB Act, a financial holdingcompany or other person that, directlyor indirectly, or acting through one ormore other persons, owns or controls 15percent or more of the equity capital of



6 Some investments are booked using ‘‘availablefor sale’’ (AFS) accounting. Under this accountingtreatment, unrealized gains are not recognized innet income, and flow to a special segregated equityaccount that is not recognized as Tier 1 capital bythe regulatory agencies. Under the current bankholding company capital rules, 45 percent of thegain on AFS equity securities may be included inTier 2 capital. The proposal would continue thistreatment but further require deduction from Tier1 capital of 50 percent of the reported cost (or fairvalue if lower for equity securities) of investmentsrecorded as AFS. The reported cost or fair value ofthese investments would be deducted from risk-weighted and average consolidated assets.

any company held under this subpart ispresumed to control that company.Equity capital includes voting andnonvoting shares, warrants, options andother instruments convertible intoequity capital. The presumption may berebutted with the agreement of theBoard and the rule allows a financialholding company to submit any relevantinformation in an effort to rebut thispresumption.

The rule also applies sections 23Aand 23B to covered transactionsbetween a U.S. branch or agency of aforeign bank and (1) any portfoliocompany controlled by the foreign bankor an affiliate of the foreign bank, and(2) any company controlled by theforeign bank or an affiliate that isengaged in making merchant bankinginvestments. For purposes ofdetermining whether a foreign bank oraffiliate controls a company, the ruleapplies the rebuttable presumptionapplicable to domestic financial holdingcompanies. These provisions promotecompetitive equity and safe and soundbanking. The rule is intended to restrictlending by a foreign bank’s branchesand agencies to portfolio companies andto affiliated companies that are actuallyengaged in making merchant bankinginvestments. It is not intended to restrictotherwise permissible lending to parentcompanies or other affiliatedcompanies, unless the proceeds of suchlending would be used by thesecompanies to make, or fund the makingof, merchant banking investments underthis subpart.

The rule recognizes that a financialholding company may make a passiveinvestment in a private equity fund. Inthis case, the rule clarifies that acompany controlled by a private equityfund will not be presumed to be anaffiliate of a depository institutioncontrolled by a financial holdingcompany that has made an investmentin the private equity fund unless thefinancial holding company controls thefund or has sponsored and advises thefund.

Comment is invited on each of theseprovisions. In particular, comment isrequested on whether there are specificsituations that should be included in therule in which the presumption undersection 23A and 23B should, by rule, beconsidered to be rebutted. Comment isalso requested on the provisionsapplying sections 23A and 23B tocertain transactions involving U.S.branches and agencies of foreign banks.

D. Capital Adequacy ProposalAs discussed above, many firms that

make merchant banking investmentsand engage in other types of investment

activities internally allocate capital tothese investments that is higher thanthey allocate to most banking assets inlight of the greater risk, illiquidity andvolatility of merchant banking andsimilar investments and the higherleverage that often is associated withportfolio companies. The internalcapital allocation for these investmentsis generally many multiples of thecurrent regulatory capital charge.

After consideration of the industrypractice and in consultation with theSecretary, the Board is proposing tomodify the methods of calculating therisk-weighted and leverage capital ratiosfor bank holding companies to betteraddress the risks associated withmerchant banking and other investmentactivities. This capital proposal, whichis described below and publishedseparately, is based on informationabout firm accounting and capitalpolicies that System and TreasuryDepartment staff gathered in interviewswith securities firms and bank holdingcompanies that currently conductmerchant banking and other investmentactivities. The Board and the Secretaryalso note that the proposed capitaltreatment is similar to the approach tocapital sufficiency that the FederalDeposit Insurance Corporation hasadopted under section 24 of the FDI Actfor investment in subsidiaries thatengage in principal activities that arenot permissible for a national bank.

The Board and the Secretary view thiscapital proposal as a precaution that isnecessary to prevent the buildup withinbanking organizations of excessive riskfrom merchant banking and otherinvestment activities. In developing thisproposal, they have considered theeffect of the proposal on the existingactivities of bank holding companies.

As an initial matter, adoption of thecapital proposal would not prevent anybank holding company from becoming afinancial holding company or fromtaking advantage of the new powersgranted under the GLB Act. The capitalcharge would be applied only at theholding company level on theconsolidated organization.Consequently, the capital proposalwould not affect the capital levels of anydepository institution—which, underthe GLB Act, determine whether acompany qualifies to be a financialholding company—controlled by a bankholding company.

In addition, the Board and theSecretary have reviewed a sampling ofcall reports of bank holding companiesengaged currently in significantinvestment activities, includingcompanies that are likely to seek tobecome financial holding companies.

This review indicates that, withvirtually no exception, bank holdingcompanies would remain wellcapitalized on a consolidated basis evenafter applying the proposed capitalcharge on all of the investmentscurrently made by these companies.Moreover, nearly all of these companieswould be able to increase significantlytheir level of investment activity andcontinue to be well capitalized on aconsolidated basis after applying theproposed capital charge.

For these reasons, the capital proposalis not expected to have an effect on thelevel of investment activities conductedby bank holding companies. The capitalproposal would, however, help to limitthe potential harm to bank holdingcompanies and depository institutionscontrolled by bank holding companiesfrom the risks associated withinvestment activities.

The proposal is being published forcomment and, unlike the rule discussedabove, is not being made effective on aninterim basis. During the commentperiod, the Board and the Secretary willdiscuss the issues raised by thisproposal with the other Federal bankingagencies and with other appropriatefunctional regulators.

Under the proposal, a financialholding company would be required todeduct from its regulatory Tier 1 capitalan amount equal to 50 percent of thetotal carrying value, as reflected onconsolidated financial statements of thefinancial holding company, of allmerchant banking investments. Thefinancial holding company woulddeduct 100 percent of the carrying valueof such investments from the assets ofthe financial holding company forcapital purposes.6

This capital charge would apply to allequity instruments and all debtinstruments that are convertible intoequity held under the merchant bankingauthority. It also would apply to all debtextended by a financial holdingcompany to a portfolio company inwhich the financial holding companyowns 15 percent or more of the totalequity. The proposal containsexceptions for short-term secured loans



for working capital purposes, for loansin which at least half has beenparticipated to third parties, and forloans that are guaranteed by the UnitedStates government. An exception is alsoproposed for extensions of credit by adepository institution controlled by thebank holding company that are fullycollateralized in accordance withsection 23A of the Federal Reserve Actand meet the other requirements of thatsection.

The proposal would apply the samecapital treatment to investments innonfinancial companies held underRegulation K, in less than 5% of theshares of any company under sections4(c)(6) or (7) of the BHC Act, heldthrough an SBIC that is controlled bythe bank holding company or asubsidiary depository institution, orheld by a state bank subsidiary inaccordance with section 24 of the FDIAct. This capital treatment would notapply to investments that are held in atrading account in accordance withapplicable accounting principles andthat are part of an underwriting, marketmaking or dealing activity. Comment isrequested on whether this exclusion isappropriate. In addition, comment isinvited on whether passive investmentsin less than 5 percent of the shares ofpublicly traded companies, where thereis a ready market, should also beexcluded or subjected to a lesser capitalcharge.

The proposal applies the capitaltreatment to nonfinancial investmentactivities conducted by bank holdingcompanies and their subsidiaries as wellas to merchant banking investments forseveral reasons. Importantly, the risksassociated with these investmentactivities do not vary according to theauthority used to conduct the activity.Thus, similar investment activitiesshould be given the same capitaltreatment regardless of the source oflegal authority to make the investment.In addition, current regulatory capitaltreatment, which applies an 8 percentminimum capital charge to investments,was developed at a time when theinvestment activities of bankingorganizations were relatively small. Inrecent years, some bank holdingcompanies have greatly expanded thelevel of their investment activities. TheBoard’s capital proposal reflects thejudgment that it is appropriate at thistime, when the investment authority ofbanking organizations has also beengreatly expanded, to revisit and reviseregulatory capital treatment for allinvestment activities.

The capital charge would not beapplied to investments made byinsurance company subsidiaries of

financial holding companies held inaccordance with section 4(k)(4)(I) of theBHC Act. The Board expects soon toseek comments on a proposal to de-consolidate functionally regulatedinsurance underwriting companies fromthe financial holding company forpurposes of applying the Board’sconsolidated capital rules. The proposalwould take account of the differentaccounting standards, businesspractices, and capital and supervisoryregimes that apply to insuranceunderwriting companies.

The Board and the Secretaryrecognize that the new authorityaccorded financial holding companiesunder the GLB Act may raise thepossibility for arbitrage between aninsurance company and its financialholding company affiliates designed toavoid the capital charges proposed formerchant banking and otherinvestments. The Board and theSecretary seek comment on whetherprovisions should be included in thefinal capital rule that would apply toinvestments made through an insurancecompany the same capital charge at theholding company level as would beapplied to merchant banking and otherinvestments if the Board finds that sucharbitrage is occurring within a particularholding company. The Board and theSecretary also invite comment onwhether there are other mechanismsthat would prevent such arbitrage.

During the period prior to adoption ofa final capital rule, financial holdingcompanies that engage in merchantbanking activities will be expected toadopt and implement internal capitaland accounting policies that reflect theliquidity, market and other risksassociated with the company’sinvestment activities. An initialcriterion for these internal capital andaccounting policies is that they becapable of enabling the financialholding company to meet the terms ofthe proposed capital rule on its effectivedate, with minimal adjustment, andremain in compliance with applicableregulatory capital standards.

The separate capital proposal requestscomment on all aspects of the proposedcapital charge, including theappropriateness of a separate capitalcharge for investment activities and theamount of the charge. For convenience,a detailed description of the proposedamendments to the Board’s capitalappendices follows.

Section II. B of Appendix A to Part225 would be amended by adding a newclause (v) at the end of the introductoryparagraph stating that portfolioinvestments must be deducted from thesum of core Tier 1 capital elements in

the manner provided by the proposal.Section II. B would also be amended byadding a new section II.B.5 governingportfolio investments. This newprovision would provide that fiftypercent (50%) of the value of allportfolio investments made by theparent bank holding company or by itsdirect or indirect subsidiaries must bededucted from the consolidated parentbanking organization’s core Tier 1capital components.

The proposal defines a portfolioinvestment as any merchant bankinginvestment made directly or indirectlyby a financial holding company undersection 4(k)(4)(H) of the BHC Act, andany investment made directly orindirectly in a nonfinancial company byany bank holding company pursuant tosection 4(c)(6), or 4(c)(7) of the BHC Act,section 211.5(b)(1)(iii) of the Board’sRegulation K, section 302(b) of theSmall Business Investment Act of 1958,or by an insured state bank subsidiaryin accordance with section 24 of the FDIAct.

For this purpose, an investmentwould include any equity instrumentand any debt instrument with equityfeatures (such as conversion rights,warrants or call options). If the bankholding company owns or controls 15percent or more of the company’s totalequity, the term also would include anyother debt instrument held by the bankholding company or any subsidiary,except for (i) any short-term, securedextension of credit provided for workingcapital purposes, (ii) any extensions ofcredit by an insured depositoryinstitution controlled by the bankholding company that is collateralizedin accordance with the requirements ofsection 23A of the Federal Reserve Actand that meets the other requirements ofthat section, (iii) any extension of creditat least 50 percent of which is sold orparticipated out to unaffiliated personson the same terms and conditions thatapplied to the initial credit, and (iv) anyextension of credit that is guaranteed bythe U.S. Government. The capital chargewould not apply to investments that areheld in the trading account inaccordance with applicable accountingprinciples and that are part of anunderwriting, market making or dealingactivity. For portfolio investments thatare reported at cost, under the equitymethod, or at fair value with unrealizedgains (or losses) included in earnings,the deduction would be equal to 50percent of the carrying value of theinvestment. For available-for-saleportfolio investments reported at fairvalue with unrealized gains (or losses)included in other comprehensiveincome, the amount of the deduction



7 For available-for-sale equity investments wherefair value is less than historical cost, the amount ofthe deduction is equal to 50 percent of reported fairvalue. The unrealized losses on such investmentsare deducted from core capital in accordance withsection II.A.1.a of the Appendix.

would equal 50 percent of the reportedcost of the investment.7 Any unrealizedgains on available-for-sale investmentsare not included in core capital, but maybe included in supplementary capital tothe extent permitted under sectionII.A.2.e of the Appendix.

For portfolio investments incompanies that are consolidated foraccounting purposes, the deductionwould equal 50 percent of the parentorganization’s investment in thecompany as determined under theequity method of accounting (net of anyintangibles associated with theinvestment that are deducted from theconsolidated bank holding company’score capital in accordance with sectionII.B.1 of the Appendix). The companywould remain fully consolidated forpurposes of determining the bankingorganization’s risk-weighted assets.

The total carrying value of anyportfolio investment subject to thededuction is excluded from the bankholding company’s weighted risk assetsfor purposes of computing thedenominator of the company’s risk-based capital ratio. For AFS portfolioinvestments, this exclusion would applyto the reported cost or, in the case ofAFS equity investments where fairvalue is less than historical cost,reported fair value.

The proposal makes conformingchanges to section II.b of Appendix D toinclude portfolio investments in the listof items that are excluded from Tier 1capital.

Regulatory Flexibility Act AnalysisIn accordance with section 3(a) of the

Regulatory Flexibility Act (5 U.S.C.603(a)), the Board must publish aninitial regulatory flexibility analysiswith this rulemaking. The ruleimplements provisions of section 103 ofthe GLB Act that allow entities that havebecome financial holding companies toenter the merchant banking business.

The interim rule includes limitedreporting and recordkeepingrequirements that apply to all financialholding companies that engage inmerchant banking, regardless of theirsize. The reporting and record keepingrequirements that the rule establishes onan interim basis are necessary to enablethe Board to execute properly itssupervisory function and to ensurecompliance by financial holdingcompanies with the limitations imposedby the GLB Act on merchant banking

activities. These statutory limits applyto all financial holding companies,regardless of size, engaged in merchantbanking activities. The Board believesthat the information required to besubmitted or retained, in most cases,would be contained in routine reports tomanagement, to third-party investors, orto other regulatory agencies, includingthe Securities and ExchangeCommission, or would be prepared andretained by an organization in thenormal conduct of its investmentactivities.

The ability of financial holdingcompanies to participate in themerchant banking business will likelyenhance their overall efficiency andability to compete effectively in themarket for corporate financial services.The Board specifically seeks commenton the likely burden that the interimrule and proposed rule will impose onfinancial holding companies that engagein merchant banking activities and otherfinancial holding companies.

Executive Order 12866 DeterminationThe Department of the Treasury has

determined that this interim rule doesnot constitute a ‘‘significant regulatoryaction’’ for purposes of Executive Order12866.

Administrative Procedure ActThe provisions of the rule are

effective on March 17, 2000 on aninterim basis. Pursuant to 5 U.S.C. 553,the Board and the Secretary of theTreasury find that it is impracticable toreview public comments prior to theeffective date of the interim rule, andthat there is good cause to make theinterim rule effective on March 17,2000, due to the fact that the rule setsforth procedures to implement statutorychanges that were recently enacted andthat became effective on March 11,2000. The Board and the Secretary ofthe Treasury are seeking publiccomment on all aspects of the interimrule and will amend the rule asappropriate after reviewing thecomments.

Subject to certain exceptions, 12U.S.C. 4802(b)(1) provides that newregulations and amendments toregulations prescribed by a federalbanking agency that impose additionalreporting, disclosure, or other newrequirements on an insured depositoryinstitution must take effect on the firstday of a calendar quarter that begins onor after the date on which theregulations are published in final form.The interim rule imposes no additionalreporting, disclosure, or other newrequirements on an insured depositoryinstitution because the new activities

that the rule governs cannot beconducted by an insured depositoryinstitution. For this reason, section4802(b)(1) does not apply to thisrulemaking.

Paperwork Reduction ActIn accordance with section 3506 of

the Paperwork Reduction Act of 1995(44 U.S.C. Ch. 35; 5 CFR 1320 AppendixA.1), the Board reviewed the interimrule under the authority delegated to theBoard by the Office of Management andBudget.

The collection of informationrequirements in the interim rule arefound in 12 CFR 225.171(d)(3); 225.172,and 225.174. This information isrequired to evidence compliance withthe requirements of Title I of the GLBAct (Pub. L. No. 106–102, 113 Stat. 1338(1999)), which amends section 4 of theBank Holding Company Act (12 U.S.C.1843), and to allow the Board toproperly exercise its supervisoryresponsibility for financial holdingcompanies. The respondents arefinancial holding companies that chooseto engage in merchant bankingactivities.

The interim rule requires that afinancial holding company submit anannual report to the Reserve Bankrelating to merchant bankinginvestments that have been held for anextended period of time and providingaggregate information on merchantbanking investments (see 12 CFR225.174(c)(1)) and file quarterly reportswith the Reserve Bank providingaggregate data on the company’smerchant banking investments (see 12CFR 225.174(c)(2)). The Board expectsto publish a separate notice to issuereporting forms that may be used tocomply with the annual and quarterlyreporting requirements. The burdenassociated with these informationcollections will be addressed at thattime.

The interim rule also requires that afinancial holding company file a noticewith the Reserve Bank within 30 daysof making a large merchant bankinginvestment (see 12 CFR 225.174(d)). Theagency form number for this declarationwill be the FR 4018. In addition, therule allows a financial holding companyto seek relief from the holding periodand aggregate investment limitsimposed by the rule by filing a requestand supporting documentation with theBoard (see 12 CFR 225.172(b) and225.173). The agency form number forthese requests will be FR 4019. Therewill be no formal reporting form forthese notices and requests. Theinformation may be submitted in theform of a letter. The Board expects to



receive very few of these notices andrequests. The Board estimates thatapproximately 250 financial holdingcompanies will engage in merchantbanking activities in the first year afteradoption of the interim rule. Of the 250financial holding companies, the Boardestimates that 100 will file these noticesand requests and that these companieswill spend approximately 1 hour toprepare these filings, resulting in anestimated annual burden of 100 hours.Based on a rate of $50 per hour, theannual cost to the public would be$5000.

The interim rule also requires that afinancial holding company engaged inmerchant banking activities establishand maintain certain policies,procedures, and systems toappropriately monitor and manage itsmerchant banking activities andmaintain certain records relating to thecompany’s merchant banking activities(see 12 CFR 225.171(d)(3), and225.174(a) and (b)). The Federal Reservebelieves that most of these internalcontrol and record keepingrequirements are consistent with thoseestablished and maintained byorganizations in the normal course ofconducting a merchant bankingbusiness. The Board estimates that the250 financial holding companies willspend approximately 5 hours incomplying with these internal controland recordkeeping requirements,resulting in an estimated annual burdenof 1,250 hours. Based on a rate of $50per hour, the annual cost to the publicwould be $62,500.

The Federal Reserve specificallyrequests comment on the accuracy ofthese burden estimates. The FederalReserve may not conduct or sponsor,and an organization is not required torespond to, an information collectionunless the Board has displayed acurrently valid OMB control number.The OMB control number for theseinformation collections is 7100–0292. Afinancial holding company may requestconfidentiality for the informationcontained in these informationcollections pursuant to section (b)(4)and (b)(6) of the Freedom of InformationAct (5 U.S.C. 552(b)(4) and (b)(6)).

Comments are invited on: (a) Whetherthe proposed collections of informationare necessary for the properperformance of the Federal Reserve’sfunctions, including whether theinformation has practical utility; (b) theaccuracy of the Federal Reserve’sestimate of the burden of the proposedinformation collections, including thecost of compliance; (c) ways to enhancethe quality, utility, and clarity of theinformation to be collected; and (d)

ways to minimize the burden ofinformation collections on respondents,including through the use of automatedcollection techniques or other forms ofinformation technology. Comments onthe collections of information should besent to the Office of Management andBudget, Paperwork Reduction Project,Washington, DC 20503, with copies ofsuch comments to be sent to Mary M.West, Federal Reserve Board ClearanceOfficer, Division of Research andStatistics, Mail Stop 97, Board ofGovernors of the Federal ReserveSystem, Washington, DC 20551.

Solicitation of Comments Regarding theUse of ‘‘Plain Language’’

Section 722 of the GLB Act requiresthe Board to use ‘‘plain language’’ in allproposed and final rules published afterJanuary 1, 2000. The Board invitescomments about how to make theinterim rule easier to understand,including answers to the followingquestions:

(1) Has the Board organized thematerial in an effective manner? If not,how could the material be betterorganized?

(2) Are the terms of the rule clearlystated? If not, how could the terms bemore clearly stated?

(3) Does the rule contain technicallanguage or jargon that is unclear? If not,which language requires clarification?

(4) Would a different format (withrespect to the grouping and order ofsections and use of headings) make therule easier to understand? If so, whatchanges to the format would make therule easier to understand?

(5) Would increasing the number ofsections (and making each sectionshorter) clarify the rule? If so, whichportions of the rule should be changedin this respect?

(6) What additional changes wouldmake the rule easier to understand?

The Board also solicits commentabout whether including factualexamples in the rule in order toillustrate its terms is appropriate. TheBoard notes that creating safe harbors inthe rule may generate certain problemsover time due to changes in technologyor business practices. Are therealternatives that the Board shouldconsider to illustrate the terms in therule?

List of Subjects

12 CFR Part 225

Administrative practice andprocedure, Banks, banking, FederalReserve System, Holding companies,Reporting and recordkeepingrequirements, Securities.

12 CFR Part 1500

Administrative practice andprocedure, Banks, banking, Holdingcompanies

Federal Reserve System

12 CFR Chapter II

Authority and Issuance

For the reasons set forth in thepreamble, the Board of Governors of theFederal Reserve System amends part225 of Chapter II, Title 12 of the Codeof Federal Regulations as follows:

PART 225—BANK HOLDINGCOMPANIES AND CHANGE IN BANKCONTROL (REGULATION Y)

1. The authority citation for part 225is revised to read as follows:

Authority: 12 U.S.C. 1817(j)(13), 1818,1828(o), 1831i, 1831p–1, 1843(c)(8), 1843(k),1844(b), 1972(l), 3106, 3108, 3310, 3331–3351, 3907, and 3909.

2. Section 225.1 is amended byredesignating paragraphs (c)(9) through(c)(13) as paragraphs (c)(11) through(c)(15), respectively, adding andreserving a new paragraph (c)(9), andadding a new paragraph (c)10 to read asfollows:

§ 225.1 Authority, purpose, and scope.

* * * * *(c) * * *(10) Subpart J governs the conduct by

financial holding companies ofmerchant banking investment activitiespermitted under section 4(k)(4)(H) of theBank Holding Company Act (12 U.S.C.1843(k)(4)H)).* * * * *

3. A new Subpart J is added to readas follows:

Subpart J—Merchant Banking Investments

Sec.225.170 What investments are permitted

under this subpart and who may makethem?

225.171 What are the limitations onmanaging or operating a portfoliocompany held as a merchant bankinginvestment?

225.172 What are the holding periodspermitted for merchant bankinginvestments?

225.173 What aggregate limits apply tomerchant banking investments?

225.174 What risk management, reportingand recordkeeping policies are requiredto make merchant banking investments?

225.175 How do the statutory crossmarketing and section 23A and 23Blimitations apply to merchant bankinginvestments?



Subpart J—Merchant BankingInvestments

§ 225.170—What investments arepermitted under this subpart and who maymake them?

(a) What investments are permittedunder this subpart? Section 4(k)(4)(H) ofthe Bank Holding Company Act (12U.S.C. 1843(k)(4)(H)) and this subpartauthorize a financial holding company,directly or indirectly and as principal oron behalf of one or more persons, toacquire or control any amount of shares,assets or ownership interests of acompany or other entity that is engagedin any activity not otherwise authorizedfor a financial holding company undersection 4 of the Bank Holding CompanyAct. For purposes of this subpart,shares, assets or ownership interestsacquired or controlled under thissubpart are referred to as ‘‘merchantbanking investments.’’ A financialholding company may not directly orindirectly acquire or control anymerchant banking investment except incompliance with the requirements ofthis subpart.

(b) Must the investment be a bona fidemerchant banking investment? Theacquisition or control of shares, assets orownership interests under this subpartis not permitted unless it is part of abona fide underwriting or merchant orinvestment banking activity.

(c) What types of ownership interestsmay be acquired? Shares, assets orownership interests of a company orother entity include any debt or equitysecurity, warrant, option, partnershipinterest, trust certificate or otherinstrument representing an ownershipinterest in the company or entity,whether voting or nonvoting.

(d) Where in a financial holdingcompany may merchant bankinginvestments be made? A financialholding company and any subsidiary(other than a depository institution orsubsidiary of a depository institution)may acquire or control merchantbanking investments. A financialholding company and its subsidiariesmay not acquire or control merchantbanking investments on behalf of adepository institution or subsidiary of adepository institution.

(e) May assets other than shares beheld directly? A financial holdingcompany may not under this subpartacquire or control assets, other thanshares or other ownership interests in acompany, unless:

(1) The assets are held within orpromptly transferred to a portfoliocompany;

(2) The portfolio company maintainspolicies, books and records, accounts,

and other indicia of corporate,partnership or limited liabilityorganization and operation that areseparate from the financial holdingcompany and that meet therequirements of § 225.174(a)(4) forlimiting the legal liability of thefinancial holding company; and

(3) The portfolio company hasmanagement that is separate from thefinancial holding company to the extentrequired by section § 225.171.

(f) What type of affiliate is required fora financial holding company to makemerchant banking investments? Afinancial holding company may notacquire or control merchant bankinginvestments under this subpart unlessthe financial holding company qualifiesunder at least one of the followingparagraphs:

(1) Securities affiliate. The financialholding company controls a companythat is registered with the Securities andExchange Commission as a broker ordealer under the Securities ExchangeAct of 1934 (15 U.S.C. 78a et seq.); or

(2) Insurance affiliate with aninvestment adviser affiliate. Thefinancial holding company controls:

(i) An insurance company that ispredominantly engaged in underwritinglife, accident and health, or propertyand casualty insurance (other thancredit-related insurance), or providingand issuing annuities; and

(ii) A company that:(A) Is registered with the Securities

and Exchange Commission as aninvestment adviser under theInvestment Advisers Act of 1940 (15U.S.C. 80b–1 et seq.); and

(B) provides investment advice to aninsurance company.

(g) What do references to a financialholding company include? The term‘‘financial holding company’’ as used inthis subpart means the financial holdingcompany and each of its subsidiaries,but, except for §§ 225.171 and 225.174,does not include a depositoryinstitution or subsidiary of a depositoryinstitution. The term includes anyprivate equity fund controlled by thefinancial holding company, but does notinclude any portfolio companycontrolled by the financial holdingcompany.

(h) What do references to a depositoryinstitution include? For purposes of thissubpart, the term ‘‘depositoryinstitution’’ includes a U.S. branch oragency of a foreign bank that acquires orcontrols, or is affiliated with a companythat acquires or controls, merchantbanking investments under this subpart.

(i) What is a portfolio company? Aportfolio company is any company orentity:

(1) That is engaged in any activity notauthorized for a financial holdingcompany under section 4 of the BankHolding Company Act; (12 U.S.C. 1843)and

(2) The shares, assets or ownershipinterests of which are held, owned orcontrolled directly or indirectly by thefinancial holding company pursuant tothis subpart.

§ 225.171 What are the limitations onmanaging or operating a portfolio companyheld as a merchant banking investment?

(a) May a financial holding companyroutinely manage or operate a portfoliocompany? Except as provided inparagraph (d) of this section, a financialholding company may not routinelymanage or operate any portfoliocompany in which it has a direct orindirect interest and any portfoliocompany held by any company(including a private equity fund) inwhich the financial holding companyhas an ownership interest under thissubpart.

(b) What does it mean to routinelymanage or operate a company? Afinancial holding company routinelymanages or operates a portfoliocompany if:

(1) Any director, officer, employee oragent of the financial holding companyserves as or has the responsibilities ofan officer or employee of the portfoliocompany;

(2) Any officer or employee of theportfolio company is supervised by anydirector, officer, employee or agent ofthe financial holding company (otherthan in that individual’s capacity as adirector of the portfolio company);

(3) Any covenant or other contractualarrangement exists between thefinancial holding company and theportfolio company that would restrictthe portfolio company’s ability to makeroutine business decisions, such asentering transactions in the ordinarycourse of business or hiring employeesbelow the rank of the five highestranking executive officers;

(4) Any director, officer, employee oragent of the financial holding company,whether in the capacity of a director ofthe portfolio company, adviser to theportfolio company, or otherwise,participates in:

(i) The day-to-day operations of theportfolio company, or

(ii) Management decisions made inthe ordinary course of business of theportfolio company other than decisionsin which a director of a companycustomarily participates in thatindividual’s capacity as a director; or (5)Any other arrangement or practice existsby which the financial holding company



routinely manages or operates theportfolio company.

(c) What arrangements do not involveroutinely managing or operating acompany? (1) Director representation atportfolio companies. A financialholding company may select any or allof the directors of a portfolio companyor have one or more directors, officers,employees or agents serve as directors ofa portfolio company if:

(i) The portfolio company employsofficers and employees responsible forroutinely managing and operating thecompany; and

(ii) The financial holding companydoes not routinely manage or operatethe portfolio company as described inparagraph (b) of this section.

(2) Covenants or other provisionsregarding extraordinary events. Afinancial holding company may, byvirtue of covenants or other writtenagreements with a portfolio company,require the portfolio company to consultwith or obtain the approval of thefinancial holding company to takeactions outside of the ordinary course ofthe business of the portfolio company,including:

(i) The acquisition of control orsignificant assets of other companies;

(ii) Significant changes to the businessplan of the portfolio company;

(iii) The redemption, authorization orissuance of any shares of capital stock(including options, warrants orconvertible shares) of the portfoliocompany; and

(iv) The sale, merger, consolidation,spin-off, recapitalization, liquidation,dissolution or sale of substantially all ofthe assets of the portfolio company orany of its significant subsidiaries.

(d) When may a financial holdingcompany manage or operate a portfoliocompany? (1) Special circumstancesrequired. A financial holding companymay routinely manage or operate aportfolio company only:

(i) When intervention is necessary toaddress a material risk to the value oroperation of the portfolio company,such as a significant operating loss orloss of senior management; and

(ii) For the period of time as may benecessary to address the cause ofinvolvement, to obtain suitablealternative management arrangements,to dispose of the investment, or tootherwise obtain a reasonable returnupon the resale or disposition of theinvestment.

(2) Approval required for extendedinvolvement. A financial holdingcompany may not routinely manage oroperate a portfolio company for a periodgreater than six months without priorapproval of the Board.

(3) Documentation required. Afinancial holding company mustmaintain and make available to theBoard a written record describing itsinvolvement in the management oroperation of a portfolio company andthe reasons therefor.

(e) May a depository institution or itssubsidiary manage or operate a portfoliocompany? (1) In general. A depositoryinstitution or subsidiary of a depositoryinstitution may not under anycircumstances manage or operate aportfolio company in which an affiliatedcompany owns or controls an interestunder this subpart.

(2) Exceptions. Paragraph (e)(1) of thissection does not prohibit—

(i) A director, officer or employee ofa depository institution or subsidiary ofa depository institution from serving asa director of a portfolio company inaccordance with the limitations set forthin this section; or

(ii) A financial subsidiary held inaccordance with section 5136A of theRevised Statutes (12 U.S.C. 24a) orsection 46(a) of the Federal DepositInsurance Act (12 U.S.C. 1831w) fromtaking actions in accordance with thelimitations set forth in this section.

§ 225.172 What are the holding periodspermitted for merchant bankinginvestments?

(a) Must investments be made forresale? A financial holding companymay own or control shares, assets andownership interests pursuant to thissubpart only for a period of time toenable the sale or disposition thereof ona reasonable basis consistent with thefinancial viability of the financialholding company’s merchant bankinginvestment activities.

(b) What period of time is generallypermitted for holding merchant bankinginvestments? (1) In general. A financialholding company may not, directly orindirectly, own, control or hold anyshare, asset or ownership interestpursuant to this subpart for a period thatexceeds 10 years, except that aninvestment in or held through a privateequity fund may be held for theduration of the fund.

(2) Ownership interests acquired fromor transferred to companies held underthis subpart. For purposes of paragraph(b)(1) of this section, any interest inshares, assets or ownership interests—

(i) Acquired by a financial holdingcompany from a company (including aprivate equity fund) in which thefinancial holding company held aninterest under this subpart will beconsidered to have been acquired by thefinancial holding company on the datethat the share, asset or ownership

interest was acquired by the company;and

(ii) Acquired by a company (includinga private equity fund) from a financialholding company will be considered tohave been acquired by the company onthe date that the share, asset orownership interest was acquired by thefinancial holding company if’

(A) The financial holding companyheld the share, asset, or ownershipinterest under this subpart; and

(B) The financial holding companyholds an interest in the acquiringcompany under this subpart.

(3) Interests previously held by afinancial holding company underlimited authority. For purposes ofparagraph (b)(1) of this section, anyshares, assets, or ownership interestspreviously owned or controlled, directlyor indirectly, by a financial holdingcompany under any other provision ofthe Federal banking laws that imposesa limited holding period will beconsidered to have been acquired by thefinancial holding company under thissubpart on the date the financialholding company first acquiredownership or control of the shares,assets or ownership interests under suchother provision of law. For purposes ofthis paragraph (b)(3), a financial holdingcompany includes a depositoryinstitution controlled by the financialholding company and any subsidiary ofsuch a depository institution.

(4) Approval required to holdinvestments held in excess of applicabletime limit. A financial holding companymay, in extraordinary circumstances,seek Board approval to own, control orhold shares, assets or ownershipinterests of a company under thissubpart for a period that exceeds theapplicable period specified in paragraph(b)(1) of this section. A request forapproval must:

(i) Be submitted to the Board no laterthan 1 year prior to the expiration of theapplicable time period;

(ii) Provide the reasons for therequest, including information thataddresses the factors in paragraph (b)(5)of this section; and

(iii) Explain the financial holdingcompany’s plan for divesting the shares,assets or ownership interests.

(5) Factors governing Boarddeterminations. In reviewing anyproposal under paragraph (b)(4) of thissection, the Board may consider all thefacts and circumstances related to theinvestment, including:

(i) The cost to the financial holdingcompany of disposing of the investmentwithin the applicable period;

(ii) The total exposure of the financialholding company to the company and



the risks that disposing of theinvestment may pose to the financialholding company;

(iii) Market conditions; and(iv) The extent and history of

involvement by the financial holdingcompany in the management andoperations of the company.

(6) Restrictions applicable toinvestments held beyond applicableperiod. A financial holding companythat directly or indirectly owns, controlsor holds any share, asset or ownershipinterest of a company under this subpartfor a total period that exceeds theapplicable period specified in paragraph(b)(1) of this section must:

(i) Deduct an amount equal to 100percent of the carrying value of thefinancial holding company’s interest inthe share, asset or ownership interestfrom the Tier 1 capital of the holdingcompany and exclude all unrealizedgains on the share, asset or ownershipinterest from its Tier 2 capital;

(ii) Not enter into any additionaltransactions, contractual arrangementsor other relationships with the companyor extend any additional credit to thecompany without Board approval; and

(iii) Abide by any other restrictionsthat the Board may impose inconnection with granting approvalunder paragraph (b)(4) of this section.

(c) What is a private equity fund? (1)Definition of a private equity fund. Forpurposes of this subpart, a ‘‘privateequity fund’’ is any company that:

(i) Is formed for the purpose of and isengaged exclusively in the business ofinvesting in shares, assets, andownership interests of companies forresale or other disposition;

(ii) Is not an operating company;(iii) Issues equity ownership interests

to at least 10 investors that are notaffiliated with, and are not officers,directors, employees or principalshareholders of the financial holdingcompany;

(iv) No more than 25 percent of thetotal equity of which is held, owned orcontrolled, directly or indirectly, by thefinancial holding company and itsdirectors, officers, employees andprincipal shareholders;

(v) That has an initial term of notmore than 12 years, which term may beextended for an additional three 1-yearperiods with the approval of personsholding a majority of the equity of thefund;

(vi) Establishes a plan for the resale ordisposition of its investments, andholds, owns or controls investmentsonly for a reasonable period of timeconsistent with making merchantbanking investments;

(vii) Maintains policies ondiversification of fund investments; and

(viii) Is not formed or operated for thepurpose of making investmentsinconsistent with the authority grantedunder section 4(k)(4)(H) of the BankHolding Company Act (12 U.S.C.1843(k)(4)(H)) or evading the limitationscontained in this subpart on merchantbanking investments.

(2) What form may a private equityfund take? A private equity fund may bea corporation, partnership, limitedliability company or other type ofcompany that issues ownership interestsin any form.

(3) May a private equity fund managea portfolio company? A private equityfund may not routinely manage oroperate a portfolio company except aspermitted by this subpart.

§ 225.173 What aggregate limits apply tomerchant banking investments?

(a) In general. A financial holdingcompany may not, without Boardapproval, directly or indirectly acquireany additional shares, assets orownership interests under this subpartor make any additional capitalcontribution to any company the shares,assets or ownership interests of whichare held by it under this subpart if theaggregate carrying value of all merchantbanking investments held by thefinancial holding company under thissubpart exceeds:

(1) The lesser of 30 percent of the Tier1 capital of the company or $6 billion;or

(2) The lesser of 20 percent of the Tier1 capital of the company or $4 billionexcluding interests in private equityfunds.

(b) Do these limits apply to interestsheld through a private equity fund?Paragraph (a) of this section does notprohibit any private equity fund that afinancial holding company controlsfrom acquiring shares, assets orownership interests.

§ 225.174 What risk management,reporting and recordkeeping policies arerequired to make merchant bankinginvestments?

(a) What internal controls arenecessary? A financial holdingcompany, including a private equityfund controlled by the financial holdingcompany, that makes investments underthis subpart must establish andmaintain policies, procedures, andsystems reasonably designed to:

(1) Monitor and adequately assess thevalue of each investment, the value ofthe aggregate portfolio, and thediversification of the portfolio;

(2) Identify and manage the market,credit, concentration and other risks

associated with merchant bankinginvestments;

(3) Monitor and review the terms,amounts and types of transactions andrelationships between the financialholding company (in the aggregate andseparately by affiliate) and eachcompany in which the financial holdingcompany has an interest under thissubpart to assess the risks and costs ofthe transactions and relationships,including whether each transaction orrelationship is on market terms, and toassure compliance with any provisionsof law, including any applicablefiduciary principles, governing thosetransactions and relationships;

(4) Ensure the maintenance ofcorporate separateness between thefinancial holding company and eachcompany in which the financial holdingcompany has an interest under thissubpart, including policies, proceduresand systems sufficient to protect thefinancial holding company anddepository institutions controlled by thefinancial holding company from legalliability for the conduct of operationsand for the financial obligations of eachsuch company; and

(5) Ensure compliance with theprovisions of this subpart governingmerchant banking investments.

(b) What records must be maintained?A financial holding company mustmaintain, at a central location, recordsand supporting information that:

(1) Are sufficient to enable the Boardto review the policies, procedures andsystems described in paragraph (a) ofthis section;

(2) Detail the cost, carrying value,market value, and performance data foreach investment made under thissubpart, including investments madethrough private equity funds;

(3) Include copies of the financialstatements of any company in which thefinancial holding company holds aninterest under this subpart, includinginvestments made through privateequity funds, and any information andvaluations provided to any co-investorsin such companies;

(4) Document any transaction orrelationship between the financialholding company and any company inwhich the financial holding companyholds an interest under this subpart thatis not on market terms; and

(5) Document any contingent fee orcontingent interest in a private equityfund or relating to any other investmentheld under this subpart, including thecarrying value and market value of suchfee or interest and the amount of suchfee or interest that has been recognizedby the financial holding company as



income but that is contingent on futureperformance or asset valuations.

(c) What periodic reports must befiled? (1) Annual reports regardingmerchant banking investments. Afinancial holding company must reportannually to the appropriate ReserveBank in such format and at such time asthe Board may prescribe:

(i) For each interest that the financialholding company owns or controlsunder this subpart (other than aninterest in or held through a privateequity fund) and that it has owned orcontrolled for a period that totals longerthan five years as of the reporting date:

(A) The identity of the company inwhich the interest is held, a descriptionof the investment and, if available, adescription of the other investors andtheir interests in the company;

(B) The historical cost of theinvestment;

(C) The market or other valuation ofthe investment as of the reporting date;and

(D) The schedule for sale ordisposition of the investment;

(ii) For each interest that the financialholding company owns or controlsunder this subpart, including an interestin or held through a private equity fund,and that it has owned or controlled fora period that totals longer than eightyears as of the reporting date:

(A) A detailed explanation of thefinancial holding company’s plan andschedule for the sale or disposition ofthe investment; and

(B) The information required underparagraph (c)(1)(i) of this section;

(iii) Aggregate data describing thenumber, total historical cost, totalcarrying value and total market value formerchant banking investments,segregated by holding period (in 2 yearincrements), geographic distribution(national or regional, as appropriate),and industrial sector.

(2) Quarterly reporting for allmerchant banking investments. Afinancial holding company must, within60 days of the end of each calendarquarter and in the format prescribed bythe Board, submit a report to theappropriate Reserve Bank of the totalnumber, aggregate historical cost andaggregate current valuation of allinvestments held pursuant to thissubpart.

(d) Is notice required for theacquisition of companies?

(1) Fulfillment of statutory noticerequirement. Except as required inparagraph (d)(2) of this section, no postacquisition notice under section 4(k)(6))of the Bank Holding Company Act (12U.S.C. 1843(k)(6)) is required by afinancial holding company in

connection with an investment madeunder this subpart if the financialholding company has previously filed anotice under § 225.87 indicating that ithad commenced activities under thissubpart.

(2) Notice of large individualinvestments. A financial holdingcompany must provide written notice tothe Board within 30 days after acquiringmore than 5 percent of the shares, assetsor ownership interests of any company,including a private equity fund, at atotal cost that exceeds the lesser of 5percent of the Tier 1 capital of thecompany or $200 million.

(3) Content of notice. A notice underparagraph (d)(2) of this section must setforth:

(i) The cost of the investment andmethod for funding the investment;

(ii) The percentage of Tier 1 capitalthat the investment represents;

(iii) A description of the company andthe type of investment; and

(iv) An explanation of the riskmanagement measures to be applied bythe financial holding company to theinvestment.

§ 225.175 How do the statutory crossmarketing and section 23A and 23Blimitations apply to merchant bankinginvestments?

(a) Are cross marketing activitiesprohibited? (1) In general. A depositoryinstitution, including a subsidiary of adepository institution, controlled by afinancial holding company may not:

(i) Offer or market, directly or throughany arrangement, any product or serviceof any company if more than 5 percentof the company’s shares, assets orownership interests are owned orcontrolled by the financial holdingcompany pursuant to this subpart; or

(ii) Allow any product or service ofthe depository institution, including anyproduct or service of a subsidiary of thedepository institution, to be offered ormarketed, directly or through anyarrangement, by or through anycompany described in paragraph(a)(1)(i) of this section.

(2) How are financial subsidiariestreated? For purposes of paragraph (a)(1)of this section, a subsidiary of adepository institution does not includea financial subsidiary held inaccordance with section 5136A of theRevised Statutes (12 U.S.C. 24a) orsection 46 of the Federal DepositInsurance Act (12 U.S.C. 1831w).

(b) When are companies held undersection 4(k)(4)(H) affiliates undersections 23A and 23B? (1) Rebuttablepresumption of control. The followingrebuttable presumption of control shallapply for purposes of sections 23A and

23B of the Federal Reserve Act (12U.S.C. 371c, 371c–1): if a financialholding company holds any shares,assets or ownership interests of acompany pursuant to this subpart, thecompany shall be presumed to be anaffiliate of any member bank that isaffiliated with the financial holdingcompany if such financial holdingcompany, directly or indirectly, owns orcontrols 15 percent or more of theequity capital of the company.

(2) Request to rebut presumption. Afinancial holding company may rebutthis presumption by providinginformation acceptable to the Boarddemonstrating that the financial holdingcompany does not control the company.

(3) Convertible instruments. Forpurposes of paragraph (b)(1) of thissection, equity capital includes options,warrants and any other instrumentconvertible into equity capital.

(4) Application of presumption toprivate equity funds. A financialholding company will not be presumedto own or control the equity capital ofa company for purposes of paragraph(b)(1) of this section solely by virtue ofan investment made by the financialholding company in a private equityfund that owns or controls the equitycapital of the company unless thefinancial holding company controls orhas sponsored and advises the privateequity fund.

(5) Application of sections 23A and23B to U.S. branches and agencies offoreign banks. Sections 23A and 23B ofthe Federal Reserve Act shall apply toall covered transactions between eachU.S. branch and agency of a foreignbank that acquires or controls, or that isaffiliated with a company that acquiresor controls, merchant bankinginvestments and—

(i) Any portfolio company that theforeign bank or affiliated companycontrols or is presumed to control underparagraph (b)(1) of this section; and

(ii) Any company that the foreignbank or affiliated company controls or ispresumed to control under paragraph(b)(1) of this section if the company isengaged in acquiring or controllingmerchant banking investments.

By order of the Board of Governors of theFederal Reserve System, March 17, 2000.Robert deV. Frierson,Associate Secretary of the Board.

Department of the Treasury

12 CFR Chapter XV

Authority and Issuance

For the reasons set forth in thepreamble, the Department of theTreasury adds part 1500 to subchapter



A of chapter XV of Title 12 of the Codeof Federal Regulations to read asfollows:

PART 1500—MERCHANT BANKINGINVESTMENTS

Sec.1500.1 How are terms defined for purposes

of this part?1500.2 What investments are permitted

under this part and who may makethem?

1500.3 What are the limitations onmanaging or operating a portfoliocompany held as a merchant bankinginvestment?

1500.4 What are the holding periodspermitted for merchant bankinginvestments?

1500.5 What aggregate limits apply tomerchant banking investments?

1500.6 What risk management, reportingand record keeping policies are requiredto make merchant banking investments?

1500.7 How do the statutory crossmarketing and sections 23A and 23Blimitations apply to merchant bankinginvestments?

Authority: 12 U.S.C. 1843(k)(4)(7).

§ 1500.1—How are terms defined forpurposes of this part?

Unless otherwise provided in thispart, all terms used in this part have themeanings given such terms in 12 CFRPart 225 (Regulation Y of the Board ofGovernors of the Federal ReserveSystem Board).

§ 1500.2—What investments are permittedunder this part and who may make them?

(a) What investments are permittedunder this part? Section 4(k)(4)(H) of theBank Holding Company Act (12 U.S.C.1843(k)(4)(H)) and this part authorize afinancial holding company, directly orindirectly and as principal or on behalfof one or more persons, to acquire orcontrol any amount of shares, assets orownership interests of a company orother entity that is engaged in anyactivity not otherwise authorized for afinancial holding company undersection 4 of the Bank Holding CompanyAct. For purposes of this part, shares,assets or ownership interests acquiredor controlled under this part are referredto as ‘‘merchant banking investments.’’A financial holding company may notdirectly or indirectly acquire or controlany merchant banking investmentexcept in compliance with therequirements of this part.

(b) Must the investment be a bona fidemerchant banking investment? Theacquisition or control of shares, assets orownership interests under this part isnot permitted unless it is part of a bonafide underwriting or merchant orinvestment banking activity.

(c) What types of ownership interestsmay be acquired? Shares, assets orownership interests of a company orother entity include any debt or equitysecurity, warrant, option, partnershipinterest, trust certificate or otherinstrument representing an ownershipinterest in the company or entity,whether voting or nonvoting.

(d) Where in a financial holdingcompany may merchant bankinginvestments be made? A financialholding company and any subsidiary(other than a depository institution orsubsidiary of a depository institution)may acquire or control merchantbanking investments. A financialholding company and its subsidiariesmay not acquire or control merchantbanking investments on behalf of adepository institution or subsidiary of adepository institution.

(e) May assets other than shares beheld directly? A financial holdingcompany may not under this partacquire or control assets, other thanshares or other ownership interests in acompany, unless:

(1) The assets are held within orpromptly transferred to a portfoliocompany;

(2) The portfolio company maintainspolicies, books and records, accounts,and other indicia of corporate,partnership or limited liabilityorganization and operation that areseparate from the financial holdingcompany and that meet therequirements of 12 CFR 225.174(a)(4) forlimiting the legal liability of thefinancial holding company; and

(3) The portfolio company hasmanagement that is separate from thefinancial holding company to the extentrequired by § 1500.3.

(f) What type of affiliate is required fora financial holding company to makemerchant banking investments? Afinancial holding company may notacquire or control merchant bankinginvestments under this part unless thefinancial holding company qualifiesunder at least one of the following:

(1) Securities affiliate. The financialholding company controls a companythat is registered with the Securities andExchange Commission as a broker ordealer under the Securities ExchangeAct of 1934 (15 U.S.C. 78a et seq.); or

(2) Insurance affiliate with aninvestment adviser affiliate. Thefinancial holding company controls:

(i) An insurance company that ispredominantly engaged in underwritinglife, accident and health, or propertyand casualty insurance (other thancredit-related insurance), or providingand issuing annuities; and

(ii) A company that:

(A) Is registered with the Securitiesand Exchange Commission as aninvestment adviser under theInvestment Advisers Act of 1940 (15U.S.C. 80b–1 et seq.); and

(B) Provides investment advice to aninsurance company.

(g) What do references to a financialholding company include? The term‘‘financial holding company’’ as used inthis part means the financial holdingcompany and each of its subsidiaries,but, except for § 1500.3, does notinclude a depository institution orsubsidiary of a depository institution.The term includes a private equity fundcontrolled by the financial holdingcompany, but does not include anyportfolio company controlled by thefinancial holding company.

(h) What do references to a depositoryinstitution include? For purposes of thispart, the term ‘‘depository institution’’includes a U.S. branch or agency of aforeign bank that acquires or controls, oris affiliated with a company thatacquires or controls, merchant bankinginvestments under this part.

(i) What is a portfolio company? Aportfolio company is any company orentity:

(1) That is engaged in any activity notauthorized for a financial holdingcompany under section 4 of the BankHolding Company Act; and

(2) The shares, assets or ownershipinterests of which are held, owned orcontrolled directly or indirectly by thefinancial holding company pursuant tothis part.

§ 1500.3 What are the limitations onmanaging or operating a portfolio companyheld as a merchant banking investment?

(a) May a financial holding companyroutinely manage or operate a portfoliocompany? Except as provided inparagraph (d) of this section, a financialholding company may not routinelymanage or operate any portfoliocompany in which it has a direct orindirect interest and any portfoliocompany held by any company(including a private equity fund) inwhich the financial holding companyhas an ownership interest under thispart.

(b) What does it mean to routinelymanage or operate a company? Afinancial holding company routinelymanages or operates a portfoliocompany if:

(1) Any director, officer, employee oragent of the financial holding companyserves as or has the responsibilities ofan officer or employee of the portfoliocompany;

(2) Any officer or employee of theportfolio company is supervised by any



director, officer, employee or agent ofthe financial holding company (otherthan in that individual’s capacity as adirector of the portfolio company);

(3) Any covenant or other contractualarrangement exists between thefinancial holding company and theportfolio company that would restrictthe portfolio company’s ability to makeroutine business decisions, such asentering transactions in the ordinarycourse of business or hiring employeesbelow the rank of the five highestranking executive officers;

(4) Any director, officer, employee oragent of the financial holding company,whether in the capacity of a director ofthe portfolio company, adviser to theportfolio company, or otherwise,participates in:

(i) The day-to-day operations of theportfolio company, or

(ii) Management decisions made inthe ordinary course of business of theportfolio company other than decisionsin which a director of a companycustomarily participates in thatindividual’s capacity as a director; or

(5) Any other arrangement or practiceexists by which the financial holdingcompany routinely manages or operatesthe portfolio company.

(c) What arrangements do not involveroutinely managing or operating acompany? (1) Director representation atportfolio companies. A financialholding company may select any or allof the directors of a portfolio companyor have one or more directors, officers,employees or agents serve as directors ofa portfolio company if:

(i) The portfolio company employsofficers and employees responsible forroutinely managing and operating thecompany; and

(ii) The financial holding companydoes not routinely manage or operatethe portfolio company as described inparagraph (b) of this section.

(2) Covenants or other provisionsregarding extraordinary events. Afinancial holding company may, byvirtue of covenants or other writtenagreements with a portfolio company,require the portfolio company to consultwith or obtain the approval of thefinancial holding company to takeactions outside of the ordinary course ofthe business of the portfolio company,including:

(i) The acquisition of control orsignificant assets of other companies;

(ii) Significant changes to the businessplan of the portfolio company;

(iii) The redemption, authorization orissuance of any shares of capital stock(including options, warrants orconvertible shares) of the portfoliocompany; and

(iv) The sale, merger, consolidation,spin-off, recapitalization, liquidation,dissolution or sale of substantially all ofthe assets of the portfolio company orany of its significant subsidiaries.

(d) When may a financial holdingcompany manage or operate a portfoliocompany? (1) Special circumstancesrequired. A financial holding companymay routinely manage or operate aportfolio company only:

(i) When intervention is necessary toaddress a material risk to the value oroperation of the portfolio company,such as a significant operating loss orloss of senior management; and

(ii) For the period of time as may benecessary to address the cause ofinvolvement, to obtain suitablealternative management arrangements,to dispose of the investment, or tootherwise obtain a reasonable returnupon the resale or disposition of theinvestment.

(2) Approval required for extendedinvolvement. A financial holdingcompany may not routinely manage oroperate a portfolio company for a periodgreater than six months without priorapproval of the Board.

(3) Documentation required. Afinancial holding company mustmaintain and make available to theBoard a written record describing itsinvolvement in the management oroperation of a portfolio company andthe reasons therefor.

(e) May a depository institution or itssubsidiary manage or operate a portfoliocompany? (1) In general. A depositoryinstitution or subsidiary of a depositoryinstitution may not under anycircumstances manage or operate aportfolio company in which an affiliatedcompany owns or controls an interestunder this part.

(2) Exceptions. Paragraph (e)(1) of thissection does not prohibit—

(i) A director, officer or employee ofa depository institution or subsidiary ofa depository institution from serving asa director of a portfolio company inaccordance with the limitations set forthin this section; or

(ii) A financial subsidiary held inaccordance with section 5136A of theRevised Statutes (12 U.S.C. 24a) orsection 46(a) of the Federal DepositInsurance Act (12 U.S.C. 1831w) fromtaking actions in accordance with thelimitations set forth in this section.

§ 1500.4 What are the holding periodspermitted for merchant bankinginvestments?

(a) Must investments be made forresale? A financial holding companymay own or control shares, assets andownership interests pursuant to this

part only for a period of time to enablethe sale or disposition thereof on areasonable basis consistent with thefinancial viability of the financialholding company’s merchant bankinginvestment activities.

(b) What period of time is generallypermitted for holding merchant bankinginvestments? (1) In general. A financialholding company may not, directly orindirectly, own, control or hold anyshare, asset or ownership interestpursuant to this part for a period thatexceeds 10 years, except that aninvestment in or held through a privateequity fund may be held for theduration of the fund.

(2) Ownership interests acquired fromor transferred to companies held underthis part. For purposes of paragraph(b)(1) of this section, any interest inshares, assets or ownership interests—

(i) Acquired by a financial holdingcompany from a company (including aprivate equity fund) in which thefinancial holding company held aninterest under this part will beconsidered to have been acquired by thefinancial holding company on the datethat the share, asset or ownershipinterest was acquired by the company;and

(ii) Acquired by a company (includinga private equity fund) from a financialholding company will be considered tohave been acquired by the company onthe date that the share, asset orownership interest was acquired by thefinancial holding company if—

(A) The financial holding companyheld the share, asset, or ownershipinterest under this part; and

(B) The financial holding companyholds an interest in the acquiringcompany under this part.

(3) Interests previously held by afinancial holding company underlimited authority. For purposes ofparagraph (b)(1) of this section, anyshares, assets, or ownership interestspreviously owned or controlled, directlyor indirectly, by a financial holdingcompany under any other provision ofthe Federal banking laws that imposesa limited holding period will beconsidered to have been acquired by thefinancial holding company under thispart on the date the financial holdingcompany first acquired ownership orcontrol of the shares, assets orownership interests under such otherprovision of law. For purposes of thisparagraph (b)(3), a financial holdingcompany includes a depositoryinstitution controlled by the financialholding company and any subsidiary ofsuch a depository institution.

(4) Approval required to holdinvestments held in excess of applicable



time limit. A financial holding companymay, in extraordinary circumstances,seek Board approval to own, control orhold shares, assets or ownershipinterests of a company under this partfor a period that exceeds the applicableperiod specified in paragraph (b)(1) ofthis section. A request for approvalmust:

(i) Be submitted to the Board no laterthan 1 year prior to the expiration of theapplicable time period;

(ii) Provide the reasons for therequest, including information thataddresses the factors in paragraph (b)(5)of this section; and

(iii) Explain the financial holdingcompany’s plan for divesting the shares,assets or ownership interests.

(5) Factors governing Boarddeterminations. In reviewing anyproposal under paragraph (b)(4) of thissection, the Board may consider all thefacts and circumstances related to theinvestment, including:

(i) The cost to the financial holdingcompany of disposing of the investmentwithin the applicable period;

(ii) The total exposure of the financialholding company to the company andthe risks that disposing of theinvestment may pose to the financialholding company;

(iii) Market conditions; and(iv) The extent and history of

involvement by the financial holdingcompany in the management andoperations of the company.

(6) Restrictions applicable toinvestments held beyond applicableperiod. A financial holding companythat directly or indirectly owns, controlsor holds any share, asset or ownershipinterest of a company under this part fora total period that exceeds theapplicable period specified in paragraph(b)(1) of this section must:

(i) Deduct an amount equal to 100percent of the carrying value of thefinancial holding company’s interest inthe share, asset or ownership interestfrom the Tier 1 capital of the holdingcompany and exclude all unrealizedgains on the share, asset or ownershipinterest from its Tier 2 capital;

(ii) Not enter into any additionaltransactions, contractual arrangementsor other relationships with the company

or extend any additional credit to thecompany without Board approval; and

(iii) Abide by any other restrictionsthat the Board may impose inconnection with granting approvalunder paragraph (4).

(c) What is a private equity fund? (1)Definition of a private equity fund. Forpurposes of this part, a ‘‘private equityfund’’ is any company that:

(i) Is formed for the purpose of and isengaged exclusively in the business ofinvesting in shares, assets, andownership interests of companies forresale or other disposition;

(ii) Is not an operating company;(iii) Issues equity ownership interests

to at least 10 investors that are notaffiliated with, and are not officers,directors, employees or principalshareholders of the financial holdingcompany;

(iv) No more than 25 percent of thetotal equity of which is held, owned orcontrolled, directly or indirectly, by thefinancial holding company and itsdirectors, officers, employees andprincipal shareholders;

(v) That has an initial term of notmore than 12 years, which term may beextended for an additional three 1-yearperiods with the approval of personsholding a majority of the equity of thefund;

(vi) Establishes a plan for the resale ordisposition of its investments, andholds, owns or controls investmentsonly for a reasonable period of timeconsistent with making merchantbanking investments;

(vii) Maintains policies ondiversification of fund investments; and

(viii) Is not formed or operated for thepurpose of making investmentsinconsistent with the authority grantedunder section 4(k)(4)(H) of the BankHolding Company Act or evading thelimitations contained in this part onmerchant banking investments.

(2) What form may a private equityfund take? A private equity fund may bea corporation, partnership, limitedliability company or other type ofcompany that issues ownership interestsin any form.

(3) May a private equity fund managea portfolio company? A private equityfund may not routinely manage or

operate a portfolio company except aspermitted by this part.

§ 1500.5 What aggregate limits apply tomerchant banking investments?

(a) In general. A financial holdingcompany may not, without Boardapproval, directly or indirectly acquireany additional shares, assets orownership interests under this part ormake any additional capitalcontribution to any company the shares,assets or ownership interests of whichare held by it under this part if theaggregate carrying value of all merchantbanking investments held by thefinancial holding company under thispart exceeds:

(1) The lesser of 30 percent of the Tier1 capital of the company or $6 billion;or

(2) The lesser of 20 percent of the Tier1 capital of the company or $4 billionexcluding interests in private equityfunds.

(b) Do these limits apply to interestsheld through a private equity fund?Paragraph (a) of this section does notprohibit any private equity fund that afinancial holding company controlsfrom acquiring shares, assets orownership interests.

§ 1500.6 What risk management, reportingand recordkeeping policies are required tomake merchant banking investments?

Certain risk management, reportingand recordkeeping requirements formerchant banking investments are setforth in the Board’s Regulation Y, 12CFR 225.174.

§ 1500.7 How do the statutory crossmarketing and sections 23A and 23Blimitations apply to merchant bankinginvestments?

Certain cross-marketing limitationsand limitations under sections 23A and23B of the Federal Reserve Actapplicable to merchant bankinginvestment are set forth in the Board’sRegulation Y, 12 CFR 225.175.

Dated: March 17, 2000.Gregory A. Baer,Assistant Secretary for Financial Institutions,Department of the Treasury.[FR Doc. 00–7147 Filed 3–27–00; 8:45 am]BILLING CODE 6210–01–U


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