8466 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

1Pub. L. 106–102, 113 Stat. 1338 (1999).

2 65 FR 16460 (March 28, 2000).

FEDERAL RESERVE SYSTEM

12 CFR Part 225

[Regulation Y; Docket No. R–1065]

DEPARTMENT OF THE TREASURY

Office of the Under Secretary for

Domestic Finance

12 CFR Part 1500

RIN 1505–AA78

Bank Holding Companies and Change

in Bank Control

AGENCIES: Board of Governors of the

Federal Reserve System and the

Department of the Treasury.

ACTION: Final rule.

SUMMARY: The Board of Governors of the

Federal Reserve System and the

Secretary of the Treasury jointly adopt

this final rule governing merchant

banking investments made by financial

holding companies. The rule

implements provisions of the GrammLeach-Bliley Act that permit financial

holding companies to make investments

as part of a bona fide securities

underwriting or merchant or investment

banking activity. The Board and the

Secretary have incorporated a number of

amendments to the final rule to address

issues raised by public commenters, to

reduce potential regulatory burdens,

and to clarify the application of the rule.

These changes include expanding the

definition of ‘‘securities affiliate’’ to

include a department or division of a

bank registered as a municipal securities

dealer; modifying the provisions

defining prohibited routine management

and operation of portfolio companies;

adopting a sunset provision for the

investment thresholds under the interim

rule and eliminating the dollar-based

threshold for the review of a financial

holding company’s merchant banking

activities; streamlining the rule’s

reporting and recordkeeping

requirements; broadening the definition

of ‘‘private equity’’ funds and clarifying

the rule’s application to such funds; and

adopting several safe-harbors to the

presumptions in the rule governing the

definition of affiliate for purposes of

sections 23A and 23B of the Federal

Reserve Act.

DATES: The final rule is effective

February 15, 2001.

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,

Counsel (202/452–3513), Legal Division;

Jean Nellie Liang, Chief, Capital Markets

(202/452–2918), Division of Research &

Statistics; Michael G. Martinson, Deputy

Associate Director (202/452–3640) or

James A. Embersit, Manager, Capital

Markets (202/452–5249), Division of

Banking Supervision and Regulation;

Board of Governors of the Federal

Reserve System, 20th Street and

Constitution Avenue, N.W.,

Washington, D.C. 20551. Users of

Telecommunications Device for the Deaf

(TDD) only contact Janice Simms at

(202) 872–4984.

Department of the Treasury: Roberta

K. McInerney, Assistant General

Counsel (Banking and Finance) (202/

622–0480), Gary Sutton, Senior Banking

Counsel (202/622–0480), or Gerry

Hughes, Senior Financial Economist

(202/622–2740), 1500 Pennsylvania

Avenue, NW., Washington, DC 20220.

SUPPLEMENTARY INFORMATION:

A. Background

The Gramm-Leach-Bliley Act (GLB

Act) 1 amended the Bank Holding

Company Act (BHC Act) to allow a bank

holding company that has made an

effective election to become a financial

holding company to make investments

in nonfinancial companies as part of a

bona fide securities underwriting or

merchant or investment banking

activity. These investments may be

made in any type of ownership interest

in any type of nonfinancial entity

(portfolio company), and may represent

any amount of the equity of a portfolio

company. Investments made under this

new authority, which is codified in

section 4(k)(4)(H) of the BHC Act (12

U.S.C. 1843(k)(4)(H)), are referred to as

‘‘merchant banking investments.’’ The

GLB Act imposed conditions on the

length of time that these investments

may be held, the ability of the financial

holding company to routinely manage

or operate the portfolio company, and

other aspects of the relationship

between the financial holding company

and its affiliates on the one hand and

the portfolio company on the other

hand. These restrictions further the

fundamental purposes of the BHC Act—

to help maintain the separation of

banking and commerce and promote

safety and soundness.

In March 2000, the Board of

Governors of the Federal Reserve

System (Board) and the Secretary of the

Treasury (Secretary) jointly adopted, on

an interim basis, and requested public

comment on a rule governing the

merchant banking investments of

financial holding companies.2 The

interim rule provided guidance

concerning the types of investments that

are permissible under section 4(k)(4)(H)

and defined the term ‘‘securities

affiliate’’ for purposes of determining

those financial holding companies

eligible to make merchant banking

investments. In addition, the interim

rule implemented the provisions of the

GLB Act that limit the holding period of

merchant banking investments and the

ability of financial holding companies to

routinely manage or operate a portfolio

company.

The interim rule also contained

provisions designed to ensure that the

merchant banking investment activities

of financial holding companies are

conducted in compliance with the GLB

Act and in a safe and sound manner that

does not endanger depository

institutions or the federal deposit

insurance funds. In this regard, the

interim rule established aggregate

investment thresholds for the review by

the Board of the merchant banking

investment activities of a financial

holding company. The Board and the

Secretary adopted these investment

thresholds to allow the agencies to

monitor the implementation of the

merchant banking investments under

the new authority and address

situations that could pose a material risk

to the safety and soundness of

depository institutions. The interim rule

also required financial holding

companies to establish policies and

procedures reasonably designed to

monitor and manage the risks associated

with merchant banking investments,

and to maintain records and file reports

necessary for the financial holding

company and the Board to monitor the

company’s merchant banking

investments and the company’s

compliance with the GLB Act and the

interim rule. Furthermore, the interim

rule implemented the cross-marketing

and affiliate transaction restrictions

applied by the GLB Act to merchant

banking investments.

At the time the Board and the

Secretary adopted the interim rule, the

Board also issued for public comment

proposed amendments to the Board’s

capital guidelines for bank holding

companies to address the appropriate

capital treatment for merchant banking

and similar investments made by bank

holding companies and their

subsidiaries. This capital proposal,

which was not adopted on an interim

basis, generally would have required

financial holding companies to deduct

50 percent of the carrying value of their

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8467

3See 65 FR 16460, 16461–62 (March 28, 2000).

4 12 U.S.C. 1843(k)(7)(A); see also 145 Cong.

Record at H11529 (daily ed. Nov. 4, 1999)

(statement by Chairman Leach) (‘‘Importantly, the

Act gives the Federal Reserve and the Treasury the

authority to jointly develop implementing

regulations on merchant banking activities that they

deem appropriate to further the purposes and

prevent evasions of the [GLB] Act and the Bank

Holding Company Act. Under the authority, the

Federal Reserve and Treasury may define relevant

terms and impose such limitations as they deem

appropriate to ensure that this new authority does

not foster conflicts of interest or undermine the

safety and soundness of depository institutions or

the Act’s general prohibitions on the mixing of

banking and commerce.’’); 145 Cong. Record

S13788 (daily ed. Nov. 3, 1999) (statement of Sen.

Sarbanes).

5See, e.g., 12 U.S.C. 1844; 12 U.S.C. 1818(b)(3).

merchant banking investments from

Tier 1 capital.

Prior to issuing the interim rule and

capital proposal, staff of the Federal

Reserve and the Department of the

Treasury conducted interviews with a

number of securities firms that make

merchant banking investments to collect

information concerning how these firms

conduct their merchant banking

activities. Staff also conducted

interviews with several bank holding

companies that were engaged in equity

investment activities prior to the GLB

Act under the more limited statutory

authorities then in existence. The

information collected in these

interviews, which is described in greater

detail in the Supplementary Information

accompanying the interim rule and

capital proposal,3 was used in

developing the interim rule and this

final rule.

B. Overview of Comments

The Board and the Secretary together

received more than 140 comments on

the interim rule and the related capital

proposal. Commenters included

Members of Congress, other federal

agencies, state banking departments,

banking organizations, securities firms,

trade associations for the banking and

securities industries, law firms and

individuals. Most comments focused on

the capital charge proposed in

conjunction with the interim rule.

Many commenters also addressed one

or more specific parts of the interim

rule. Some commenters suggested that

the Board and the Secretary should

eliminate or significantly modify the

interim rule’s aggregate investment

thresholds, holding period limitations

or routine management and operation

restrictions and instead rely on the

examination and supervisory process to

address potential safety and soundness

concerns and administer and enforce

the GLB Act’s provisions that are

designed to help maintain the

separation of banking and commerce. A

number of commenters contended that

these provisions would frustrate

Congress’ desire to permit a ‘‘two-way’’

street between securities firms and

banking organizations or place financial

holding companies at a disadvantage in

competing with nonbank organizations

in making merchant banking

investments.

Some commenters also contended

that the Board and the Secretary lacked

the authority to establish aggregate

investment thresholds and maximum

holding periods for merchant banking

investments or to limit the period of

time that a financial holding company

may routinely manage or operate a

portfolio company without Board

approval. Several commenters argued

that the Board and the Secretary lacked

the legal authority to determine that, in

every case without exception, certain

types of officer and employee interlocks

and investor covenants represent

routine management of the portfolio

company.

Many commenters suggested specific

amendments to the interim rule to

clarify its application, reduce potential

burden or provide financial holding

companies additional flexibility in

making merchant banking investments.

For example, some commenters

requested that the Board and the

Secretary extend the permissible

holding periods for merchant banking

investments or streamline the process

for seeking approval to hold a merchant

banking investment beyond the periods

specified in the rule. Some commenters

suggested that the agencies expand the

types of relationships that a financial

holding company may have with a

portfolio company without becoming

involved in the routine management or

operations of the company or expand

the circumstances under which a

financial holding company may

routinely manage or operate a portfolio

company. In addition, some

commenters requested that the agencies

streamline the rule’s recordkeeping and

reporting requirements, or clarify or

streamline application of the rule to

private equity funds.

C. Explanation of Final Rule

The Board and the Secretary have

carefully reviewed the comments

received on the interim rule in light of

the language and purposes of the GLB

Act and the BHC Act. After this review,

the Board and the Secretary have

modified the interim rule in a number

of respects. In particular, the Board and

the Secretary have—

• Expanded the definition of

‘‘securities affiliate’’ to include a

registered municipal securities dealer,

including a division or department of a

bank that is registered as a municipal

securities dealer under the Securities

Exchange Act of 1934, thereby

broadening the eligibility of financial

holding companies to make merchant

banking investments under the rule;

• Modified the provisions defining

actions that represent routine

management or operation, clarified the

circumstances under which a financial

holding company may routinely manage

and operate a portfolio company, and

extended the period of time that a

financial holding company may

routinely manage or operate a portfolio

company without providing notice to

the Board;

• Broadened the definition of private

equity funds and created a new section

of the rule (section 225.173) that

explains how the holding period and

management and operations restrictions

of the rule apply to private equity funds;

• Adopted an automatic sunset

provision for the investment thresholds

contained in the interim rule and

eliminated the dollar-based threshold

for Board review of the merchant

banking investment activities of a

financial holding company during the

period before the sunset;

• Streamlined the recordkeeping and

reporting provisions of the rule to

reduce burden;

• Clarified the circumstances in

which the cross-marketing provisions

apply; and

• Adopted three safe harbors to the

rebuttable presumptions established

under sections 23A and B of the Federal

Reserve Act.

These changes as well as the agencies’

responses to the comments received are

discussed in greater detail below.

As an initial matter, the Board and the

Secretary believe that the rule is both

within the statutory authority of the

agencies and consistent with the

language and purposes of the GLB Act

and BHC Act. The GLB Act specifically

authorizes the Board and the Secretary

to issue such regulations implementing

section 4(k)(4)(H) as the Board and the

Secretary jointly deem appropriate to

assure compliance with the purposes

and prevent evasions of the BHC Act

and the GLB Act and to protect

depository institutions.4 This authority

supplements the authority granted the

Board by the BHC Act and other federal

law to supervise bank holding

companies and issue regulations and

orders, including reporting and record

keeping requirements, to administer and

carry out the purposes of the BHC Act

and prevent evasions thereof.5

8468 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

6Subpart I of the Board’s Regulation Y sets forth

the procedures and qualification criteria applicable

to bank holding companies that seek to elect to

become a financial holding company. See 12 CFR

225.81 et seq.; 66 FR 400 (Jan. 3, 2001).

7See 12 U.S.C. 1843(k)(6)(A); 12 CFR 225.87(a).

As discussed in detail below, the rule

defines the scope of activities permitted

by section 4(k)(4)(H) and implements

the provisions of section 4(k)(4)(H) that

are designed to limit the potential

mixing of banking and commerce. The

rule also contains provisions that are

designed to protect the safety and

soundness of depository institutions, as

well as recordkeeping and reporting

provisions that the agencies believe are

appropriate to monitor compliance

with, and prevent evasions of, the BHC

Act and the GLB Act.

The Board and the Secretary believe

that the rule permits a ‘‘two-way’’ street

between securities firms and banking

organizations while, at the same time,

giving effect to the statutory limitations

and framework adopted by Congress to

help maintain the separation of banking

and commerce and ensure the safety

and soundness of depository

institutions. Moreover, the Board and

the Secretary believe that adoption of a

rule, rather than reliance primarily on

the supervisory process, is the most

appropriate method for ensuring the fair

and effective administration of the GLB

Act’s merchant banking provisions and

preventing evasions of those provisions.

The rule provides financial holding

companies and members of the public

with notice of the limitations generally

applicable to merchant banking

investment activities. The rule also

allows the Board to grant exceptions to

the general investment thresholds,

holding period, and affiliate transaction

limits included in the rule if the facts of

a particular case demonstrate that the

exemption is consistent with the

purposes of the GLB and BHC Acts. The

Board intends also to continue to rely

on the supervisory process to monitor

compliance by financial holding

companies with the rule and to address

any safety and soundness issues that

may arise with respect to the merchant

banking investments of individual

financial holding companies.

Section 225.170—What Type of

Investments Are Permitted by This

Subpart, and Under What Conditions

May They Be Made?

Section 4(k)(4)(H) and the rule permit

a financial holding company to acquire

or control any amount of shares, assets,

or ownership interests of any company

or other entity that is engaged in an

activity not otherwise authorized for the

financial holding company under

section 4 of the BHC Act. Thus, section

4(k)(4)(H) and the rule permit a

financial holding company directly or

indirectly to acquire or control the

shares, assets, or ownership interests of

a company or other entity that is

engaged in any activity that is not

financial in nature, incidental to a

financial activity or otherwise

permissible for the financial holding

company under section 4 of the BHC

Act. Shares, assets and ownership

interests acquired or controlled

pursuant to section 4(k)(4)(H) and the

rule are referred to as ‘‘merchant

banking investments.’’ A financial

holding company may acquire or

control merchant banking investments

only in accordance with the

requirements of the rule.

Section 4(k)(4)(H) and the rule allow

a financial holding company to acquire

the full range of ownership interests in

a company, including securities,

warrants, partnership interests, trust

certificates, and other instruments

representing an ownership interest in a

company, whether the interest is voting

or nonvoting. A financial holding

company also may acquire any

instrument convertible into a security or

other ownership interest under the rule.

In addition, a financial holding

company may acquire any amount of

ownership interests in a company or

other entity under the rule, whether or

not that amount results in control for

purposes of the BHC Act. Thus, this

merchant banking authority gives a

financial holding company the

flexibility to acquire or control a

nominal amount, a majority, or all of the

shares or other ownership interests of a

portfolio company.

Securities Affiliate

The GLB Act grants authority to make

merchant banking investments only to a

bank holding company that becomes a

financial holding company,6 and either

(1) controls or is a ‘‘securities affiliate’’

or (2) controls both an insurance

underwriter affiliate and an investment

adviser affiliate registered under the

Investment Advisers Act of 1940 that

provides investment advice to an

insurance company. In addition, the

financial holding company must

provide notice to the Board within 30

days after commencing merchant

banking investment activities or

acquiring any company that makes

merchant banking investments.7

The interim rule defined a ‘‘securities

affiliate’’ to include any broker or dealer

registered with the Securities and

Exchange Commission (SEC) under the

Securities Exchange Act of 1934

(Exchange Act). Commenters generally

supported the rule’s broad definition of

‘‘securities affiliate.’’ Some commenters

also requested that the definition be

expanded to include a separately

identifiable division or department of a

bank that is registered as a municipal

securities dealer under section 15B of

the Exchange Act, a small business

investment company, or any affiliate

predominantly engaged in the purchase,

sale or underwriting of securities.

After considering the comments, the

Board and the Secretary have amended

the definition of securities affiliate to

include a registered municipal

securities dealer, including a separately

identifiable division or department of a

bank that is registered as a municipal

securities dealer under the Exchange

Act. A division or department that is

registered with the SEC as a municipal

securities dealer performs many of the

same functions as a separately

incorporated registered securities broker

or dealer and would be considered to be

a type of securities broker or dealer if

the division or department were

incorporated outside the bank. The

Board and Secretary also have amended

the rule to clarify that a financial

holding company may make merchant

banking investments if the holding

company is itself a registered securities

broker or dealer.

The agencies do not believe at this

time that an SBIC or a company that

purchases securities for investment or

other purposes without becoming a

registered securities broker or dealer are

securities affiliates for purposes of

section 4(k)(4)(H). Commenters making

these suggestions provided no evidence

that Congress intended the term

‘‘securities affiliate’’ to cover companies

that do not engage in significant levels

of securities activities.

Authority Limited to Making

Investments in Companies Engaged in

Nonfinancial Activities

As discussed above, the rule

authorizes a financial holding company

to acquire or control investments in a

company or other entity that is engaged

in any activity that is not otherwise

authorized for the financial holding

company under section 4 of the BHC

Act. Some commenters asserted that

section 4(k)(4)(H) should be construed

to permit financial holding companies

to make investments in financial

companies under their merchant

banking authority. These commenters

suggested that any investment made by

a financial holding company for

investment purposes, rather than for

strategic or operating purposes, should

be considered a merchant banking

investment regardless of the activities

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8469

8Nothing in section 4(k)(4)(H) or the rule

overrides the prior approval requirements of section

3 of the BHC Act that govern the acquisition of

shares of a bank or bank holding company or the

provisions of section 4(k)(6) and 4(j) of the BHC Act

that govern the acquisition of shares of a savings

association or a company that controls a savings

association.

9See, e.g., 12 U.S.C. 1843(l)(2); 12 CFR 225.84.

10Although the rule does not apply to

investments held under section 4(c)(6) or 4(c)(7) or

the Board’s Regulation K, those authorities are only

available if the financial holding company’s

aggregate investment in the relevant company

under a combination of authorities—including any

investment made under the merchant banking

authority—is within the applicable investment

limitations and restrictions set forth in section

4(c)(6), 4(c)(7) or Regulation K.

11 12 U.S.C. § 1843(k)(4)(H).

12Concentration in particular industries or in

individual investments may present supervisory

concerns. The Board expects all financial holding

companies that engage in merchant banking

investment activities to establish policies governing

portfolio diversification and to maintain capital that

is adequate in light of the company’s investment

portfolio. See Federal Reserve SR Letter No. 00–9

(SPE) (June 22, 2000).

conducted by the acquired company.

Other commenters requested that the

Board and Secretary clarify that the rule

does not apply to investments made by

financial holding companies or other

banking organizations under legal

authorities other than section 4(k)(4)(H).

The language of section 4(k)(4)(H)

authorizes a financial holding company

to acquire or control a company or

entity ‘‘engaged in any activity not

authorized pursuant to [section 4 of the

BHC Act].’’ Financial holding

companies have separate authority

under other provisions of the BHC Act

to make investments in companies

engaged in financial activities. Section

4(k)(4)(H) does not restrict the authority

of financial holding companies to

acquire or control ownership interests

in companies engaged in financial

activities. Rather, it authorizes financial

holding companies to make investments

in companies that would otherwise be

prohibited. Together, these sets of

authorities allow financial holding

companies, without prior approval in

most cases, to acquire ownership

interests in any type of company other

than a depository institution.8

The rule does not prohibit a financial

holding company from using a

combination of authorities to invest

through the same subsidiary or fund in

ownership interests of both nonfinancial

companies and financial companies. In

addition, a company held as a merchant

banking investment may be engaged in

both nonfinancial and financial

activities, so long as the investment

otherwise complies with the

requirements of the rule. Similarly, a

financial holding company may retain a

merchant banking investment in a

nonfinancial company even if the

company subsequently commences a

financial activity.

Because section 4(k)(4)(H) does not

authorize investments in financial

companies, the restrictions contained in

the rule, such as the restrictions on

holding periods and cross-marketing, do

not apply to investments by financial

holding companies in financial

companies that are made under other

provisions of the BHC Act and the

Board’s Regulation Y—whether such

investments are made for strategic

reasons or for purposes of reselling the

investment. A financial holding

company may not, however, use the

merchant banking authority as a means

of evading restrictions, such as consent

or approval requirements or restrictions

that address conflicts of interest, that

govern the acquisition of financial

companies under the BHC Act or the

Board’s Regulation Y.9

The authority granted by section

4(k)(4)(H) of the BHC Act to financial

holding companies to make merchant

banking investments also is an

alternative to any other authority that a

financial holding company may have to

make investments in nonfinancial

companies under other provisions of the

BHC Act. For example, the rule does not

address or apply to investments

acquired as part of securities

underwriting, dealing or market making

activities conducted under section

4(k)(4)(E) of the BHC Act, investments

made by insurance underwriting

subsidiaries of a financial holding

company in accordance with section

4(k)(4)(I) of the BHC Act, investments

made under section 4(c)(6) or 4(c)(7) of

the BHC Act, or investments made

overseas under the Board’s Regulation

K.10

Merchant Banking Investments Must Be

Made as Part of a Bona Fide

Underwriting or Merchant or

Investment Banking Activity

The GLB Act and the rule provide that

a financial holding company may make

merchant banking investments only as

part of a bona fide underwriting or

merchant banking or investment

banking activity.11 When issuing the

interim rule, the Board and the

Secretary noted that this requirement

was intended to distinguish between

merchant banking investments that, by

their very nature, are made for purposes

of resale or other disposition, and

investments that are made for purposes

of allowing the financial holding

company to engage in the nonfinancial

activities conducted by the portfolio

company. The GLB Act and the rule do

not authorize a financial holding

company to make an investment in a

nonfinancial company for the purpose

of engaging in the activities of the

nonfinancial company and, in this way,

the ‘‘bona fide’’ requirement preserves

the financial nature of merchant

banking investment activities and helps

further the GLB Act’s purpose of

maintaining the separation of banking

and commerce.

As the agencies stated in the

Supplementary Information

accompanying the interim rule, the

Board intends to monitor the merchant

banking investment activities of

financial holding companies through

the supervisory process to ensure that

all merchant banking investments are

made in compliance with the Act’s

‘‘bona fide’’ requirement and that

financial holding companies do not use

the merchant banking authority as a

means of becoming impermissibly

involved in nonfinancial activities, such

as real estate investment or

development. Some commenters

expressed concern that the Board and

the Secretary intended to discourage or

prohibit financial holding companies

from making merchant banking

investments in companies engaged in

real estate investment or development

activities.

In considering whether an investment

meets the rule’s ‘‘bona fide’’

requirement, the Board will consider all

the relevant facts and circumstances

surrounding the investment, including

the financial holding company’s

documented purpose for making the

investment and overall relationship

with the portfolio company. The ‘‘bona

fide’’ requirement does not prohibit a

financial holding company from

specializing in making merchant

banking investments in particular

industries or from making its first

merchant banking investment in a

company engaged in real estate

investment or development, provided

such investments are made for

investment purposes as part of an

ongoing underwriting or investment or

merchant banking activity and are

otherwise held in accordance with the

requirements of the rule.12

Investments May Be Made Directly or

Through Funds

A financial holding company may

acquire or control merchant banking

investments directly or through any

subsidiary other than a depository

institution or subsidiary of a depository

8470 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

13A financial subsidiary may make merchant

banking investments only if, after five years of the

date of enactment of the GLB Act, the Board and

the Secretary jointly adopt rules in accordance with

section 122 of the GLB Act that permit financial

subsidiaries to make merchant banking

investments.

institution.13 A financial holding

company also may not acquire or

control merchant banking investments

on behalf of a depository institution or

subsidiary of a depository institution. In

order to assure competitive equality

between U.S. and foreign banking

organizations conducting merchant

banking activities, the rule provides that

a U.S. branch or agency of a foreign

bank is considered a ‘‘depository

institution’’ for purpose of the rule.

Accordingly, a U.S. branch or agency of

a foreign bank may not acquire or

control merchant banking investments

under the rule, and merchant banking

investments may not be acquired or

controlled on behalf of a U.S. branch or

agency of a foreign bank.

As discussed more fully below, the

rule allows a financial holding company

to make merchant banking investments

through a private equity fund or other

investment fund that itself makes

investments in nonfinancial companies.

Where a financial holding company

makes an investment in a private equity

fund or other fund that in turn makes

merchant banking investments, the

investment by the holding company in

the fund is considered a ‘‘merchant

banking investment’’ and must comply

with the requirements of the rule. As

described further below, the rule

provides certain benefits for

investments in or held through a

qualifying private equity fund,

including an extended holding period

and certain relief from the rule’s crossmarketing restrictions. Investments in

funds that do not qualify as private

equity funds are treated as any other

type of merchant banking investment

held under the rule.

Definition of Portfolio Company and

Financial Holding Company

Certain of the rule’s requirements—

such as the restrictions on routine

management and operation—apply only

with respect to ‘‘portfolio companies.’’

The rule defines a ‘‘portfolio company’’

to mean any company or entity that is

directly or indirectly held, owned or

controlled by a financial holding

company using the merchant banking

authority and that is engaged in an

activity that is not authorized for the

financial holding company under

section 4 of the BHC Act. (See section

225.177).

As a general matter, a ‘‘financial

holding company’’ is defined for

purposes of the rule to mean the

financial holding company and any

direct or indirect subsidiary of the

holding company. The term does not

include (i) a portfolio company that is

controlled by the financial holding

company, or (ii) a depository institution

controlled by the financial holding

company or any subsidiary of such a

depository institution. As discussed

below, the definition of financial

holding company is modified to include

depository institutions and certain types

of affiliates of the financial holding

company for purposes of certain

provisions governing routine

management.

Requirement That Assets Be Acquired

by or Transferred to a Portfolio

Company

As noted above, the rule permits a

financial holding company to acquire

any type of ownership interest in a

portfolio company. The interim rule

also permits a financial holding

company to acquire and control ‘‘assets’’

other than debt or equity securities or

other ownership interests of a company.

These assets may, for example, be real

estate or the assets of a division of an

operating company. To be permissible

under the interim rule, the assets must

be acquired through, or promptly

transferred to, a portfolio company that

has and maintains separate corporate

existence, management, and operations

to the extent otherwise required by the

rule. (See § 225.170(e)(3).) Some

commenters asserted that the rule

should allow a financial holding

company directly to acquire and hold

all types of nonfinancial assets.

The final rule retains the requirement

of the interim rule that a financial

holding company hold any nonfinancial

assets acquired as a merchant banking

investment through a portfolio company

that is separate from the financial

holding company. The agencies believe

that this requirement is consistent with

the language of section 4(k)(4)(H), which

allows a financial holding company to

acquire only assets ‘‘of a company.’’ In

addition, this requirement facilitates

compliance with the routine

management and operation restrictions

of the Act by interposing separate

management between the financial

holding company and any nonfinancial

assets acquired, and enhances safety

and soundness by providing the benefits

of corporate separation.

Section 225.171—What Are the

Limitations on Managing or Operating a

Portfolio Company Held as a Merchant

Banking Investment?

The GLB Act prohibits a financial

holding company from routinely

managing or operating a portfolio

company except as may be necessary or

required to obtain a reasonable return

on the resale or disposition of the

investment. The interim rule addressed

a number of arrangements that would

not be considered to represent routinely

managing or operating a company and

that would, therefore, be permissible at

any time as well as arrangements that

represent routinely managing or

operating a company. In particular, the

interim rule provided that a financial

holding company would generally not

be considered to routinely manage or

operate a portfolio company by having

one or more representatives on the

board of directors of the portfolio

company, or by requiring a portfolio

company (through written covenants or

otherwise) to obtain the financial

holding company’s approval to take

actions outside the ordinary course of

business, such as the acquisition of

another company; the sale,

recapitalization or liquidation of the

portfolio company; the issuance of

additional capital stock; or making

significant changes to the portfolio

company’s business plan. On the other

hand, the interim rule also provided

that a financial holding company would

be considered to be routinely managing

or operating a portfolio company if a

director, officer, employee or agent of

the financial holding company served as

an officer or employee of the portfolio

company, or if the financial holding

company (through written covenants or

otherwise) restricted the ability of the

portfolio company to make routine

business decisions.

The interim rule permitted a financial

holding company to routinely manage

or operate a portfolio company when

such action was necessary to address a

material risk to the value or operation of

the portfolio company. In these special

situations, a financial holding company

was required to obtain the Board’s

approval if the company routinely

managed or operated a portfolio

company for more than 6 months.

Commenters supported the agencies’

decision to allow financial holding

companies to have director interlocks

with portfolio companies. Commenters

also supported allowing an investing

company to participate in decisions by

the portfolio company that are outside

the ordinary course of business. These

commenters viewed these actions as

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8471

14An ‘‘executive officer’’ does not include a

person who may exercise a certain measure of

discretion in the performance of their duties,

including the discretion to make decisions in the

ordinary course of business, but who does not

participate in the determination of major policies of

the company and whose decisions are limited by

policy standards fixed by senior management. In

addition, the term does not include any person who

is excluded from participating (other than in the

capacity of a director) in major policymaking

functions of the company by resolution of the board

of directors of by the bylaws of the company

provided the person does not in fact participate in

such policymaking functions.

necessary protections for investors that

did not involve the investor in the dayto-day management or operations of the

portfolio company.

Many commenters, however, also

requested that the Board and Secretary

expand the types of relationships that a

financial holding company may have

with a portfolio company without being

deemed to be routinely managing or

operating the portfolio company. For

example, commenters argued that the

agencies should permit a financial

holding company to have some officer

or employee interlocks with a portfolio

company on either a permanent or

temporary basis. Commenters

contended that an interlocking

employee or junior officer would not

necessarily involve the financial

holding company in routinely managing

or operating the company or in many

cases confer authority on the financial

holding company to make management

decisions at the portfolio company.

Commenters also requested that the

agencies strike the rule’s prohibition on

‘‘agents’’ of a financial holding company

serving as officers or employees of a

portfolio company in light of the

potential breadth and ambiguity of the

term. In addition, commenters requested

that the rule allow a financial holding

company to have any type of ‘‘negative’’

covenant or other type of covenant as

part of an investment in a portfolio

company, and to participate in

decisions regarding the hiring or firing

of the portfolio company’s independent

accountant and lower-level officers and

employees.

Commenters also asserted that the

interim rule improperly limited the

circumstances when a financial holding

company is permitted to routinely

manage or operate a portfolio company

and the length of time such involvement

may exist. In particular, commenters

argued that section 4(k)(4)(H) allows a

financial holding company to routinely

manage or operate a portfolio company

when ‘‘necessary or required to obtain a

reasonable return on [the] investment

upon resale or disposition.’’ Some

commenters asserted that this standard

would be met if the portfolio company

experienced a decline in profitability or

the loss of key customers or personnel.

Some commenters also asserted that the

rule should not place any time limit on

a financial holding company’s

involvement in the routine management

or operations of a portfolio company or,

alternatively, should allow a financial

holding company to routinely manage

or operate a portfolio company for a

period longer than 6 months without

Board approval.

As discussed below, the final rule

contains modifications that address

these points.

Relationships That Involve Routine

Management or Operation

Section 225.171(a) of the rule

implements the GLB Act’s general

prohibition on a financial holding

company routinely managing or

operating any portfolio company. As

explained below, the final rule retains

the definition of certain types of

relationships as representing routinely

managing or operating a portfolio

company contained in the interim rule.

The rule has been modified in several

cases to construct presumptions that

certain types of relationships represent

routine management or operation, and

to allow financial holding companies to

have these relationships where they do

not result in routine management or

operation.

The agencies continue to believe that

in all circumstances an executive officer

of a company is involved in the day-today management or operations of the

company and participates in

management and operational decisions

that occur in the ordinary course of the

company’s business and, thus, is

involved in routinely managing or

operating the company. For this reason,

the final rule continues to provide that

a financial holding company routinely

manages or operates a portfolio

company if any director, officer or

employee of the financial holding

company serves as, or has the

responsibilities of, an executive officer

of the portfolio company. The final rule

defines the term ‘‘executive officer’’ in

the same manner as the Board’s

Regulation O. As a general matter, this

definition includes any person who

participates or has the authority to

participate (other than in the capacity as

a director) in major policymaking

functions of the portfolio company,

whether or not the officer has an official

title, the title designates the officer as an

assistant, or the officer serves without

salary or other compensation. (See

section 225.177(d); 12 CFR

215.2(e)(1).)14 The agencies believe

using this definition, which is familiar

to banking organizations, will facilitate

compliance with the rule.

The final rule also provides that a

financial holding company routinely

manages or operates a portfolio

company if an executive officer of the

parent financial holding company or of

certain of its major subsidiaries becomes

an officer or employee of the portfolio

company. These executive officers are

the highest officers of the financial

holding company and its major

subsidiaries and, by definition, exercise

management and operational control

over the financial holding company and

its subsidiaries. In the context of a

situation in which the financial holding

company is a direct or indirect investor

in a portfolio company, allowing these

executive officers to serve as an officer

or employee of the portfolio company

would permit the financial holding

company to routinely manage or operate

the portfolio company.

Finally, the final rule provides that

covenants or agreements that restrict the

portfolio company’s ability to make

routine business decisions represent

routinely managing or operating the

portfolio company. Covenants or

agreements affected by this provision

include restrictions on the portfolio

company entering into transactions in

the ordinary course of business or hiring

non-executive officers or employees. As

explained below, the rule permits

covenants and agreements that restrict

actions that are outside the ordinary

course of business. In response to

several comments, the final rule also

permits covenants or other

arrangements that govern the

employment of any or all of the

‘‘executive officers’’ of a portfolio

company (rather than just the 5 highest

ranking officials of the portfolio

company, as in the interim rule).

As noted above, the final rule

modifies several other restrictions

contained in the interim rule from

absolute prohibitions to rebuttable

presumptions. In particular, the

agencies believe that, in most

circumstances, a financial holding

company would become involved in the

day-to-day management or operations of

a portfolio company if a director, officer

or employee of the financial holding

company serves as a non-executive

officer or employee of the portfolio

company or if an officer or employee of

the portfolio company is supervised by

or reports to an officer or employee of

the financial holding company. The

agencies also recognize, however, that

there may be cases where the specific

facts demonstrate that such a

relationship with the portfolio company

8472 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

15See 12 CFR 225.28(b)(6) and 225.86(b)(1).

16See 12 CFR 225.28(b)(9) and 225.86(b)(1).

17 12 U.S.C. 1843(k)(4)(H)(iv).

would not involve the investing

financial holding company in routinely

managing or operating the company.

Accordingly, the agencies have

modified the rule to establish a

rebuttable presumption that these

relationships represent routine

management or operation of a portfolio

company. In addition, in response to

commenters, the reference in these

presumptions to ‘‘agents’’ of the

financial holding company has been

deleted because the term is ambiguous.

The rule allows a financial holding

company to request a determination

from the Board that a presumption of

routine management or operations is

rebutted. (See section 225.171(c).) Any

request to rebut a presumption should

fully describe all the facts and

circumstances related to the financial

holding company’s investment in, and

relationships with, the portfolio

company.

Relationships That Do Not Constitute

Routine Management or Operation

Section 225.171(d) of the final rule

identifies relationships with a portfolio

company that would not involve a

financial holding company in routinely

managing or operating the portfolio

company. The list of relationships

included in section 225.171(d) is not

intended to be a complete list of the

types of contacts or relationships that a

financial holding company may have

with a portfolio company without being

deemed to routinely manage or operate

the portfolio company. Instead, the list

is intended to identify types of

relationships that commonly occur with

a portfolio company and that would not

involve the financial holding company

in routinely managing or operating the

portfolio company.

1. Director interlocks. The final rule

continues to permit a financial holding

company to have one or more

representatives on the board of directors

of a portfolio company. Consistent with

the Board’s existing interpretations, the

selection of the partners (including the

general partner) of a partnership is

considered to be the equivalent of

selecting the directors of a company. A

representative of a financial holding

company that serves as a director of a

portfolio company may participate fully

in those matters that are typically

presented to directors of a company,

whether the director participates in

these matters at a meeting of the board,

at meetings of committees of the board,

through written votes, through meetings

with officers or employees of the

portfolio company or otherwise.

The financial holding company’s

director representatives, however, may

not participate in the day-to-day

operations of the portfolio company or

in management decisions that are made

in the ordinary course of business and

not customarily presented to the

directors of a company. In this manner,

the rule prevents a financial holding

company from using a person that is

nominally designated as a director to

routinely manage or operate a portfolio

company. In order for a financial

holding company to have a director

interlock and not be deemed to be

routinely managing or operating the

portfolio company, the portfolio

company also must have officers and

employees that routinely manage and

operate the company, and the financial

holding company must not have other

arrangements or relationships with the

portfolio company that would involve

the financial holding company in the

routine management or operation of the

portfolio company.

2. Covenants concerning actions

outside the ordinary course of business.

The final rule permits a financial

holding company to restrict, by

covenant or otherwise, the ability of a

portfolio company to take actions

outside the ordinary course of business.

In response to comments, the final rule

contains an expanded list of examples

of actions that are outside the ordinary

course of business and that may be

subject to these types of covenants or

agreements. These examples are—

• The acquisition of significant assets

or control of another company by the

portfolio company or any of its

subsidiaries;

• The removal or selection of the

portfolio company’s independent

accountant or investment banker;

• Significant changes to the portfolio

company’s business plan or accounting

methods or policies;

• The removal or replacement of any

or all of the executive officers of the

portfolio company;

• The redemption, authorization or

issuance of any equity or debt securities

of the portfolio company;

• Any borrowing by the portfolio

company that is outside the ordinary

course of business;

• The amendment of the portfolio

company’s articles of incorporation or

by-laws or similar governing

documents; and

• The sale, merger, consolidation,

spin-off, recapitalization, liquidation,

dissolution or sale of substantially all of

the assets of the portfolio company or

any of its significant subsidiaries.

The examples included in the rule are

not exclusive and are intended only to

illustrate the types of actions that a

financial holding company may restrict,

by covenant or otherwise, without

becoming involved in the routine

management or operations of the

portfolio company.

3. Providing advisory and

underwriting services to, and consulting

with, a portfolio company. The final

rule also clarifies that a financial

holding company does not routinely

manage or operate a portfolio company

by providing financial, investment or

management consulting advisory

services to the portfolio company as

otherwise permitted by the Board’s

Regulation Y.15 Any management

consulting services provided to a

portfolio company must remain solely

advisory in nature, and the financial

holding company may not assume

responsibility for decision-making or for

the day-to-day management or

operations of the portfolio company.16

In addition, the final rule clarifies that

a financial holding company may

underwrite or act as placement agent for

the securities of a portfolio company

and provide assistance to the portfolio

company in connection with the

underwriting or placement of its

securities without being considered to

be involved in routinely managing or

operating the company. The rule also

clarifies that a financial holding

company may have regular or periodic

meetings with the officers or employees

of a portfolio company to monitor and

provide advice regarding the portfolio

company’s performance or activities so

long as the financial holding company,

through such meeting or otherwise, does

not routinely manage or operate the

portfolio company.

These provisions were added to the

final rule to address questions raised by

commenters. They are not intended to

identify all of the contacts that may be

permissible between a financial holding

company and a portfolio company.

When May a Financial Holding

Company Routinely Manage or Operate

a Portfolio Company?

Section 4(k)(4)(H) permits a financial

holding company to routinely manage

or operate a portfolio company when

such action is ‘‘necessary or required to

obtain a reasonable return on [the]

investment upon resale or

disposition.’’ 17 The Board and the

Secretary have amended the rule to

incorporate this statutory standard. The

final rule also provides examples of

situations where intervention by a

financial holding company might be

necessary or required to obtain a

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8473

reasonable return, such as when the

portfolio company experiences a

significant operating loss or the loss of

senior management. The situations

listed in the rule as examples are not

intended to represent an exclusive list

of situations when a financial holding

company may permissibly intervene in

the routine management or operation of

a portfolio company.

The agencies note, however, that once

the financial holding company has

taken appropriate actions to obtain a

reasonable return on the resale or

disposition of the investment, the GLB

Act requires the financial holding

company to cease routinely managing or

operating the portfolio company.

Accordingly, the rule provides that a

financial holding company may

routinely manage or operate a portfolio

company only for the period of time as

may be necessary to address the cause

of the holding company’s involvement

in the routine management or

operations of the portfolio company, to

obtain suitable management

arrangements, to dispose of the

investment or to otherwise obtain a

reasonable return upon the resale or

disposition of the investment.

The Board and the Secretary

recognize that the determination

whether and how long intervention by

the financial holding company is

necessary or required will depend on

the facts and circumstances associated

with the particular investment. The

final rule includes two requirements to

assist the Board in monitoring

interventions by financial holding

companies in the routine management

or operations of portfolio companies to

ensure that such actions are consistent

with the GLB Act’s limitations.

First, the rule requires financial

holding companies to maintain and

make available to the Board upon

request a written record describing the

company’s involvement in routinely

managing or operating a portfolio

company (see section 225.171(e)(4)).

Second, the rule requires that a financial

holding company provide the Board

written notice if the company routinely

manages or operates a portfolio

company for more than 9 months (see

section 225.171(e)(3)). This notice

procedure substitutes for the prior

approval process included in the

interim rule. The notice may be in letter

form and should identify the portfolio

company, the date on which the

financial holding company first became

involved in the routine management or

operations of the portfolio company, the

reasons for the involvement, the actions

that the financial holding company has

taken to address the circumstances

giving rise to the intervention, and an

estimate of when the financial holding

company anticipates ceasing routinely

managing or operating the portfolio

company. These records and notice will

permit the Board to monitor the

company’s involvement in routinely

managing or operating a portfolio

company to assure that such actions

remain consistent with the GLB Act and

the rule.

Depository Institutions Prohibited From

Managing or Operating Portfolio

Companies

The final rule provides that a

depository institution and a subsidiary

of a depository institution may not

routinely manage or operate a portfolio

company held by a financial holding

company under the rule. Depository

institutions and their subsidiaries are

not authorized to make merchant

banking investments or to routinely

manage or operate portfolio companies

acquired by an affiliated financial

holding company. The rule is not

intended to prevent a depository

institution from having covenants or

from taking actions pursuant to

covenants that are typically found in

credit agreements to ensure repayment

of extensions of credit in the ordinary

course of business where the covenant

or action is not an attempt to evade the

restrictions of this subpart. To ensure

competitive equality, this limitation

would also apply to U.S. branches and

agencies of foreign banks.

The rule does not prohibit a director,

officer or employee of a depository

institution (or subsidiary of a depository

institution) or U.S. branch or agency

from serving as a director of a portfolio

company to the same extent as would be

permitted for a director, officer or

employee of a financial holding

company or to take other actions that

the rule does not define to be routine

management or operation. In order to

clarify these points, the rule includes a

depository institution and its

subsidiaries in the definition of

financial holding company for purposes

of the provisions defining routine

management and operation. In addition,

the rule does not apply the prohibition

on routinely managing or operating a

portfolio company to a financial

subsidiary held in accordance with

section 5136A of the Revised Statutes or

section 46 of the Federal Deposit

Insurance Act, or to a subsidiary that is

a small business investment company

held in accordance with the Small

Business Investment Act of 1958, so

long as the subsidiary exercises routine

management or operation in accordance

with the limitations that apply to

financial holding companies under this

subpart. As noted above, an affiliated

depository institution may not,

however, routinely manage or operate a

portfolio company under section

225.171(e).

Section 225.172—What Are the Holding

Periods Permitted for Merchant Banking

Investments?

The GLB Act requires that shares,

assets, and ownership interests be held

only for a period of time that enables the

sale or disposition of the interest on a

reasonable basis consistent with the

financial viability of the financial

holding company’s merchant banking

activities. The interim rule included this

statutory limitation and implemented it

by establishing holding periods

governing the retention of merchant

banking investments by financial

holding companies. Financial holding

companies could hold merchant

banking investments beyond the periods

established by the rule only with the

approval of the Board.

Permissible Holding Periods for

Merchant Banking Investments

The interim rule generally permitted

financial holding companies to hold any

merchant banking investment for a

period of up to 10 years. In addition, the

rule allowed financial holding

companies to hold an interest in a

private equity fund for the life of the

fund, up to 15 years. Financial holding

companies could hold any merchant

banking investment for a longer period

with the Board’s approval.

The holding periods included in the

rule reflect information collected by

Federal Reserve and Treasury staff from

a number of securities firms that

currently make merchant banking

investments and from several bank

holding companies that have relatively

large portfolios of similar equity

investments that were made under legal

authorities that pre-date the GLB Act. In

developing these holding periods, the

Board and the Secretary also considered

the System’s experience in supervising

the equity investment activities of bank

holding companies under these preexisting authorities.

These data indicate that merchant

banking and similar investments

typically are held only for relatively

short periods of time. Although the

holding period for individual

investments vary, these data indicate

that the average holding period for

investments under current market

conditions is approximately 5 years,

with a shorter average holding period

for investments held through private

equity funds and other pooled

8474 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

investment vehicles. These data also

indicate that investments are only rarely

held for a period in excess of 10 years.

Several commenters, including

banking organizations active in equity

investment activities and a securities

trade association, concurred that the

holding periods established by the

interim rule generally are consistent

with industry practice and that

merchant banking investments are only

occasionally held beyond the periods

permitted by the rule. Another banking

trade association also fully supported

the holding periods included in the

interim rule, noting that the periods

were consistent with Congress’ intent to

maintain the separation between

banking and commerce.

A number of commenters, on the

other hand, asserted that Congress

intended to leave the decision of when

to sell a merchant banking investment to

the discretion of the financial holding

company. These commenters argued

that establishing a regulatory holding

period for merchant banking

investments would place financial

holding companies at a competitive

disadvantage or require financial

holding companies to dispose of

investments prematurely. Some

commenters recommended that the

agencies eliminate or delay adoption of

any fixed holding periods and rely on

the supervisory process to enforce the

limitations in the GLB Act restricting

the period of time that merchant

banking investments may be held. In

addition, several commenters suggested

that the agencies allow all merchant

banking investments to be held for up

to 15 years without approval, or

establish a regulatory holding period

that is based on the average holding

period of the merchant banking

investment portfolio of the financial

holding company.

After carefully considering the

comments in light of the language and

purposes of the GLB Act and BHC Act,

the agencies have retained the holding

period provisions of the interim rule

with several modifications discussed

below. Under the final rule, a financial

holding company, without any prior

approval, may own or control a

merchant banking investment for up to

10 years, and may own or control an

investment in or held through a private

equity fund for the duration of the fund,

up to 15 years. The agencies have not

amended the rule to use the average

duration of a financial holding

company’s merchant banking portfolio

as the criteria for measuring compliance

with the rule’s holding periods. Because

merchant banking investments typically

are held for only short periods of time,

adopting an average duration approach

could allow a financial holding

company to retain individual merchant

banking investments for an extended

and virtually indefinite period of time

in conflict with the purposes of the GLB

and BHC Acts.

The agencies believe that the holding

periods in the rule are appropriate to

implement the limitation in section

4(k)(4)(H) that allows financial holding

companies to own or control a merchant

banking investment only for ‘‘a period

of time to enable the sale or disposition

thereof on a reasonable basis consistent

with the financial viability’’ of the

financial holding company’s merchant

banking investment activities, and are

consistent with the purpose of the GLB

Act and BHC Act to maintain the

separation between banking and

commerce.

Nevertheless, the Board and the

Secretary recognize that there may be

circumstances where retention of a

merchant banking investment beyond

the periods established by the rule

would be appropriate and consistent

with the limitations in, and purposes of,

the GLB and BHC Acts. Accordingly, the

rule continues to allow a financial

holding company to retain any

merchant banking investment beyond

the periods set forth in the rule with the

Board’s approval. This process provides

financial holding companies with the

flexibility to retain merchant banking

investments beyond the holding periods

in the rule where the financial holding

company can demonstrate that such

retention is necessary to enable the sale

or other disposition of the investment

on a reasonable basis and is otherwise

consistent with the GLB and BHC Acts.

The rule lists the factors that the

Board will consider in reviewing a

request for an extension of the

applicable holding period. These factors

include the cost to the financial holding

company of disposing of the investment

within the applicable time period; the

total exposure of the financial holding

company to the portfolio company and

the risks that disposing of the

investment without an extension may

pose to the financial holding company;

market conditions; the nature of the

portfolio company’s business; the extent

and history of the financial holding

company’s involvement in the

management and operations of the

portfolio company; and the average

holding period of the financial holding

company’s merchant banking

investments. The Board may also

consider any other relevant information

related to the investment.

In response to comments, the agencies

also have streamlined the process for

obtaining the Board’s approval to retain

a merchant banking investment beyond

the applicable holding period. The final

rule provides that an extension request

must be filed at least 90 days (rather

than 1 year, as in the interim rule) prior

to the expiration of the holding period.

Any request for an extension must

provide the reasons for the request

(including information that addresses

the factors discussed above) and explain

the financial holding company’s plan

for divesting the investment. A financial

holding company may request

confidential treatment of any

information included in a request in

accordance with the Freedom of

Information Act (5 U.S.C. 552 et seq.)

and the Board’s Rules Regarding the

Availability of Information (12 CFR Part

261).

The final rule provides that, in

connection with granting any extension,

the Board may impose restrictions that

the Board determines to be appropriate

in the circumstances. The agencies have

eliminated all but one of the restrictions

that will be applied by rule in all cases

to investments held beyond the

applicable holding period. In particular,

the final rule retains an automatic

capital charge for investments that are

held for an extended period. The capital

charge must be set by the Board at a rate

that is above the highest marginal

capital charge that would apply to

investments made by that financial

holding company under the final capital

rules governing merchant banking

investments, and may not be below 25

percent of the adjusted carrying value of

the investment as reflected on the

balance sheet of the financial holding

company.

The final rule does not include the

provisions from the interim rule

prohibiting a financial holding company

from entering into any additional

transactions with any company held

beyond the applicable holding period,

including making additional extensions

of credit to the company or acquiring

additional shares of the company.

Removal of these restrictions from the

rule recognizes that, in individual

circumstances, the acquisition of

additional shares of a portfolio company

or the addition of certain relationships

or transactions (such as participation in

underwriting the company’s initial

public offering) may facilitate the

prompt sale of the portfolio company.

The Board, in connection with granting

a request to hold an investment beyond

the applicable holding period, may

determine to impose these or other

restrictions if such restrictions are

appropriate in the individual case.

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8475

18See, e.g., 12 U.S.C. 1843(c)(2) (maximum 10-

year holding period for shares or assets acquired in

satisfaction of a debt previously contracted).

Tacking Rules

A few commenters recommended that

the agencies eliminate the special

holding period ‘‘tacking’’ provisions

included in section 225.172(b)(2) and

(3) of the interim rule. These

commenters asserted that the tacking

provisions, which are designed to

prevent evasions of the rule’s holding

periods, might prevent a financial

holding company from receiving

securities as part of the liquidation of an

investment fund. Commenters also

argued that the agencies should rely on

the supervisory process to uncover

evasions of the holding periods.

The final rule retains the tacking

provisions included in the interim rule.

The Board and the Secretary believe

these provisions are appropriate to

prevent a financial holding company

from evading the holding periods

applicable to merchant banking and

certain other types of investments under

the banking laws.18 In particular, these

provisions prevent a financial holding

company from attempting to circumvent

the holding periods on merchant

banking investments by transferring a

merchant banking investment from one

company or fund to another. The rule

also provides that, for purposes of

calculating compliance with the

merchant banking holding periods, an

investment acquired by the financial

holding company under another

authority that imposes a restriction on

the amount of time that the financial

holding company may hold the

investment is considered to have been

acquired on the original acquisition

date.

Section 225.173—How Are Investments

in Private Equity Funds Treated Under

This Subpart?

Securities firms typically make a

significant percentage of their merchant

banking investments through funds that

are limited partnerships or other

investment vehicles that pool the firm’s

capital with capital provided by thirdparty investors. These investors

typically are institutional investors,

such as other investment companies,

pension funds, endowments, financial

institutions or corporations, and

sophisticated individual investors with

high net worth. In most instances, the

securities firm is the sponsor or adviser

to the fund and has a general

partnership or similar interest in the

fund. Securities firms also make noncontrolling investments in funds that

are sponsored and advised by

unaffiliated companies.

These pooled investment vehicles

frequently have characteristics, such as

limited terms, manager compensation

arrangements, and the presence of thirdparty investors that monitor

investments, that encourage the fund to

dispose of its investments in a relatively

short period of time. In light of these

factors, the interim rule contained a

number of features designed to

accommodate merchant banking

investment activities conducted through

a qualifying ‘‘private equity fund.’’

These features included a longer

holding period designed to reflect the

industry practice with private equity

funds, a higher aggregate investment

threshold for review of an organization

that makes investments in or through

private equity funds, and streamlined

reporting and recordkeeping provisions

for investments in, or held through,

private equity funds.

Commenters generally supported the

decision to provide regulatory benefits

to merchant banking investments that

are made in or through private equity

funds. A number of commenters argued

that private equity funds should be

completely exempted from all or some

of the rule’s requirements, including the

rule’s provisions related to holding

periods, routinely managing or

operating portfolio companies, crossmarketing activities and recordkeeping

and reporting requirements. Other

commenters urged the agencies to

clarify or reduce the requirements

applicable to private equity funds that

are not controlled by a financial holding

company.

Commenters also requested

modification of the interim rule’s

definition of a ‘‘private equity fund’’ in

several respects. For example, a number

of commenters asserted that a private

equity fund should be permitted to have

a term of more than 15 years or have

fewer than 10 investors that are not

affiliated with the financial holding

company. A few commenters stated that

the agencies should permit a financial

holding company to own or control

more than 25 percent of the total equity

of a fund without losing the benefits

that accrue to a private equity fund.

Some commenters urged elimination of

the requirement that a private equity

fund maintain policies on

diversification.

In light of the comments, the agencies

have retained the special treatment for

investments made in or through private

equity funds. The final rule contains a

number of modifications to the

definition of ‘‘private equity fund’’ to

address matters raised by commenters.

In addition, the final rule has been

reorganized to add a new section

225.173 that includes the definition of

a ‘‘private equity fund’’ and describes

how the rule’s holding periods and

routine management and operation

restrictions apply to private equity

funds. The agencies believe these

changes make it easier for users to

understand how the rule applies to

private equity funds.

Definition of Private Equity Fund

The agencies have modified and

expanded the definition of a ‘‘private

equity fund’’ in the final rule in

response to public comments. The

agencies believe the definition included

in the final rule is consistent with

prevalent industry practice and ensures

that a private equity fund retains the

characteristics that encourage it to be

operated in a manner consistent with

the requirements of the GLB Act.

Under the final rule, a private equity

fund qualifies for the special provisions

of the rule if the fund has a fixed

duration of not more than 15 years

including all potential extensions, and

the financial holding company

(including its officers, directors,

employees and principal shareholders)

does not own more than 25 percent of

the total equity of the fund. The rule

does not impose any limits on advisory

fees or on the various types of incentive

compensation that the financial holding

company may receive for services

rendered to the fund provided that such

fees do not increase the financial

holding company’s equity stake in the

fund above the rule’s 25 percent

threshold.

The final rule eliminates the

requirement that the fund have a

specific number of outside investors, the

requirement that the fund establish a

plan for the resale of each of its

investments and the requirement that

the fund maintain diversification

policies. The agencies believe that the

purposes of these restrictions are served

by the limitations noted above on the

amount of the fund that may be owned

or controlled by the financial holding

company and by the remaining

provisions. These provisions require

that the fund not be an operating

company, engage exclusively in the

business of investing in financial and

nonfinancial companies for resale or

other disposition, and not be established

or operated for the purpose of making

investments that are inconsistent with

section 4(k)(4)(H) of the BHC Act or

evading the limitations on merchant

banking activities contained in the GLB

Act or the rule. As described below, the

fund must have policies and systems for

8476 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

19The holding period tacking rules set forth in

section 225.172(b)(2) and (3) and described above

must be applied in determining whether a private

equity fund investment has been held longer than

the period permitted by the rule. 20See 12 U.S.C. 1841(g)(1).

monitoring and addressing the various

risks associated with merchant banking

activities.

The final rule retains the provisions of

the interim rule that allow a private

equity fund to be organized in any form,

including as a partnership, corporation

or limited liability company. In

addition, the fund may, but need not be,

registered as an investment company

under the Federal securities laws.

Permissible Holding Period for Private

Equity Fund Investments

The final rule permits a financial

holding company, without Board

approval, to own or control an

investment in a private equity fund that

makes merchant banking investments

for the duration of the fund, which may

be up to 15 years. The rule contemplates

that a qualifying private equity fund

may hold investments in portfolio

companies for the duration of the fund.

Accordingly, a private equity fund that

conducts merchant banking investment

activities in accordance with the rule is

not required to dispose of its

investments within the 10 year period

applicable to other types of merchant

banking investments.

A financial holding company may

seek the Board’s approval to retain an

investment in a qualifying private

equity fund or to extend the duration of

a private equity fund for a period longer

than 15 years in special

circumstances.19 Any request must be

filed at least 90 days prior to the

expiration of the holding period and

include the information described in

section 225.172(b)(4) of the rule. If the

Board grants the extension request, the

financial holding company must apply

the capital charge described in section

225.172(b)(6) of the rule to the financial

holding company’s investment in the

fund and must comply with any other

restrictions imposed by the Board.

Application of Routine Management

and Operation Restrictions to Private

Equity Funds

The GLB Act and the rule prohibit a

financial holding company in most

circumstances from routinely managing

or operating any portfolio company—

that is, any company engaged in

nonfinancial activities. (See sections

225.177(c) and 225.171(a)). The final

rule also provides that a financial

holding company may not routinely

manage or operate a portfolio company

that is owned or controlled by a private

equity fund in which the financial

holding company owns or controls any

ownership interest, except in the

limited circumstances permitted by

section 225.171(e) of the rule. The rule

does not prohibit a financial holding

company from routinely managing or

operating a private equity fund.

Some commenters urged the agencies

not to limit the ability of a private

equity fund to routinely manage or

operate a portfolio company under any

circumstances. The final rule has been

modified in two respects in response to

the comments on this matter. First, the

final rule applies the restriction on

routine management or operation of

portfolio companies only to private

equity funds that are controlled by a

financial holding company and to the

financial holding company. Second, the

final rule permits a financial holding

company to invest in a private equity

fund that routinely manages a portfolio

company so long as the financial

holding company does not control the

private equity fund and the financial

holding company does not routinely

manage or operate the portfolio

company, except as permitted in the

special circumstances explained above

in section 225.171(e).

These changes are based on the view

that a financial holding company is

considered to be acting through any

fund that it controls. On the other hand,

in cases in which the financial holding

company does not control the private

equity fund, the actions of the private

equity fund should not be attributed to

the financial holding company. These

changes are also consistent with other

provisions of the BHC Act, which

provide that a financial holding

company would generally not be

considered indirectly to control a

company that is owned by an

intermediate company unless the

financial holding company controls the

intermediate company.20

In the case of a private equity fund

that is controlled by a financial holding

company, the agencies do not believe

that it is consistent with the terms or

purposes of section 4(k)(4)(H) or the

BHC Act to allow the private equity

fund to routinely manage or operate

portfolio companies. Section 4(k)(4)(H)

prohibits a financial holding company

from routinely managing or operating a

portfolio company. This prohibition

applies whether the financial holding

company acts directly or acts indirectly,

including through a company, such as a

private equity fund, that is controlled by

the financial holding company. The

agencies also believe that allowing a

fund that is controlled by a financial

holding company to routinely manage a

portfolio company would remove the

separation between banking and

commerce that the restriction on routine

management was intended to preserve.

Accordingly, the rule continues to

apply the routine management

restrictions to any private equity fund

controlled by a financial holding

company. The final rule defines

situations in which a financial holding

company is considered to control a

private equity fund. This definition is

based on the provisions of the BHC Act

and takes account of the special

relationship that advisers have to

investment funds.

Under the final rule, a financial

holding company is considered to

control a private equity fund if the

financial holding company, including

any director, officer, employee or

principal shareholder of the company,

(1) serves as a general partner, managing

member or trustee of the private equity

fund; (2) owns or controls in the

aggregate 25 percent or more of any

class of voting shares or similar interests

in the fund; or (3) selects, controls or

constitutes a majority of the directors,

trustees or management of the fund.

Interviews with securities firms and

banking organizations that advise and

operate private equity funds, as well as

the Board’s experience in supervising

the pooled investment vehicles advised

and operated by banking organizations

under pre-existing authorities, indicate

that the adviser of a fund typically

establishes the policies that govern the

fund’s investments and operations,

makes investment and disposition

decisions on behalf of the fund, and

otherwise controls the fund and its

operations. In light of this information

and experience, the rule also provides

that a financial holding company is

deemed to control a private equity fund

for purposes of the rule if the company

owns more than 5 percent of any class

of voting shares or similar ownership

interests in the fund and serves as the

fund’s investment adviser.

Other Matters Related to Private Equity

Funds

Commenters requested guidance

regarding how the other provisions of

the rule would apply to investments in

private equity funds that are not

controlled by a financial holding

company. As explained above, in

circumstances where a financial holding

company has a passive (i.e.,

noncontrolling) investment in a private

equity fund that is advised and

controlled by an unaffiliated entity, any

shares owned by the fund generally are

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8477

21See 12 U.S.C. 1841(g)(1); 12 CFR 225.2(e)(2)(i).

not considered to be owned or

controlled by the passive financial

holding company investor.21

Accordingly, the final rule clarifies that

the restrictions on cross-marketing the

products or services of a portfolio

company, the limitations of sections

23A and 23B of the Federal Reserve Act,

and the reporting and recordkeeping

requirements of the rule, do not apply

with respect to investments in portfolio

companies that are held by a private

equity fund in which the financial

holding company holds a

noncontrolling interest. These

restrictions and requirements (other

than the cross-marketing restrictions)

would, however, apply to the financial

holding company’s investment in the

private equity fund and govern the

relationship of the financial holding

company with the private equity fund.

Funds That Are Not Qualifying Private

Equity Funds

Although the rule permits certain

advantages to funds that meet the rule’s

definition of a private equity fund, the

rule also permits financial holding

companies to invest in and control a

fund that does not meet the rule’s

definition of a private equity fund. If the

financial holding company controls the

non-qualifying fund, then the provisions

of the rule, including the provisions

governing the holding periods for

portfolio companies, the routine

management restrictions, the riskmanagement and recordkeeping

requirements, the cross-marketing

provisions, and the section 23A

provisions, apply to investments made

by the non-qualifying fund in the same

manner as those provisions would apply

if the investment in the portfolio

company were held directly by the

financial holding company. If the

financial holding company owns a

noncontrolling interest in the fund, then

the fund is itself considered to be a

portfolio company and provisions of the

rule apply to that investment in the

same way as they apply to any other

investment in a portfolio company.

Thus, under the rule, a financial

holding company may own more than

25 percent of the equity of a fund that

has an unlimited life (and, consequently

is not a qualifying private equity fund),

so long as the fund does not hold

investments in portfolio companies for

more than the 10-year holding period

that would apply if the financial

holding company held the investment

in the portfolio company directly and

the fund complies with the routine

management and other restrictions in

the rule. Similarly, a financial holding

company may invest in a fund that, in

addition to making merchant banking

investments, engages in other

businesses (and, consequently is not a

qualifying private equity fund), so long

as the financial holding company does

not control the fund, divests its interest

in the fund within the 10-year holding

period, and complies with the other

provisions of the rule that apply to other

investments in a portfolio company.

This approach allows financial

holding companies flexibility to

conduct merchant banking investment

activities in a variety of ways that are

consistent with the restrictions and

purposes of the BHC Act and the GLB

Act. At the same time, the preferences

in the rule for qualifying private equity

funds recognize that funds meeting

those definitions more regularly include

structural incentives and features that

reinforce the requirements and purposes

of those Acts, and present fewer

opportunities to evade those

requirements.

Section 225.174—What Aggregate

Thresholds Apply to Merchant Banking

Investments?

The interim rule required that a

financial holding company receive the

Board’s prior approval to make

additional merchant banking

investments if the carrying value of the

company’s existing merchant banking

investments exceeded either of two

supervisory thresholds. These

thresholds were designed to allow the

Board to monitor the policies and risk

management practices of a financial

holding company that devotes

significant resources to merchant

banking activities. The Board and the

Secretary also indicated that the

supervisory limits included in the

interim rule were transitional in nature,

and would be reviewed once rules

governing the regulatory capital

treatment of merchant banking

investments were in place and the

agencies and industry gained experience

with managing and supervising

investments under the new merchant

banking authority.

Under the interim rule, a financial

holding company met the first threshold

if the aggregate carrying value of all of

its merchant banking investments

exceeded the lesser of 30 percent of the

company’s Tier 1 capital or $6 billion.

A financial holding company met the

second threshold if the aggregate

carrying value of its merchant banking

investments-excluding interests in

private equity funds-exceeded the lesser

of 20 percent of the company’s Tier 1

capital or $4 billion. These thresholds

apply only to merchant banking

investments made under section

4(k)(4)(H) and the rule, and do not apply

to investments that are held under other

authorities, such as investments made

through SBICs under the Small Business

Investment Act, in less than 5 percent

of the voting shares of a company under

section 4(c)(6) or 4(c)(7) of the BHC Act,

or in companies overseas under

Regulation K.

Numerous commenters argued that

these supervisory thresholds were

unnecessary. Some commenters

contended that the Board and the

Secretary lacked the legal authority to

impose the thresholds, or that the

thresholds adopted were arbitrary and

not supported by sufficient evidence.

Commenters also asserted that the

thresholds—and particularly the dollarbased thresholds—would have an unfair

impact on larger organizations that have

significant investment portfolios and

organizations whose investment

portfolios have experienced significant

increases in value. Some commenters

also contended that the thresholds

would place financial holding

companies at a competitive

disadvantage to other firms making

merchant banking investments or would

discourage securities firms from seeking

to become a financial holding company.

Commenters also offered a number of

suggested revisions to the thresholds if

they were retained. For example,

commenters suggested that the agencies

should remove the dollar-based

thresholds from the rule; exempt

organizations with significant

investment experience from the review

provisions; provide higher thresholds

for organizations with diversified

portfolios; base the thresholds on the

historical cost (rather than the carrying

value) of merchant banking investments;

or establish a definitive sunset date for

the review process.

The Board and the Secretary believe

that the risk to a financial holding

company and its depository institution

subsidiaries from merchant banking

investments increases as the level of

equity investments increases as a

percentage of the financial holding

company’s capital. This is particularly

true if the financial holding company

has not established appropriate risk

management policies, procedures, and

controls (including capital reserves) to

manage and control the significant

potential risks that arise from having a

substantial portion of the company’s

capital exposed to fluctuations in equity

prices.

The Board and the Secretary also

believe that the financial risks from

merchant banking activities are best

8478 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

22See Federal Reserve SR Letter No. 00–9 (SPE)

(June 22, 2000) (‘‘SR Letter’’). The SR Letter applies

to financial holding companies engaged in making

merchant banking investments under section

4(k)(4)(H) and the rule, as well as all bank holding

companies that make equity investments in

nonfinancial companies through SBICs or under

section 4(c)(6) or 4(c)(7) of the BHC Act.

addressed by appropriate capital levels

and by strong risk management policies

and practices. The agencies note that the

Federal banking agencies are working

towards a new minimum regulatory

capital proposal for equity investment

activities.

While the appropriate regulatory

capital standards are being developed

and companies and the agencies are

gaining experience in developing and

implementing appropriate risk

management practices and policies, the

Board and the Secretary continue to

believe that it is appropriate to monitor

and review the practices of financial

holding companies that commit a

significant portion of their capital to

new merchant banking investments. For

these reasons, the agencies have

retained the process for reviewing the

policies and practices governing

merchant banking activities of a

financial holding company. However,

the final rule specifically provides that

this provision will remain in effect only

until a final rule addressing the

appropriate regulatory capital treatment

of merchant banking and other equity

investment activities is adopted and

becomes effective.

The agencies have modified in two

respects the review thresholds

contained in the interim rule. First, the

final rule eliminates the absolute dollar

thresholds contained in the interim rule.

Second, the final rule has been modified

to clarify that the rule’s review

thresholds apply to the investment

made by a financial holding company in

a private equity fund, but do not apply

to the fund itself or to investments in

the fund made by unaffiliated third

parties. The thresholds also do not

restrict the ability of a financial holding

company to make additional

investments in a fiduciary capacity on

behalf of its trust customers.

The Board and the Secretary believe

that the agencies have the authority

under the GLB Act, BHC Act and other

federal banking laws to adopt

supervisory thresholds governing

merchant banking investments. The

agencies also believe that the thresholds

and review process included in the

interim rule and the final rule are

consistent with the purposes of the GLB

Act, BHC Act and other Federal banking

laws and are appropriate to protect

depository institutions that are affiliated

with financial holding companies

engaged in merchant banking

investment activities

Section 225.175—What Risk

Management, Record Keeping and

Reporting Policies Are Required To

Make Merchant Banking Investments?

The interim rule required a financial

holding company to adopt policies,

procedures and systems reasonably

designed to manage the risks associated

with making merchant banking

investments and to monitor compliance

with the statutory and regulatory

provisions governing such investments.

These policies, procedures and systems

must be reasonably designed to, among

other things, allow the financial holding

company to monitor and adequately

assess the value of the company’s

merchant banking investments (both

individually and in the aggregate) and

the diversification of the company’s

merchant banking investment portfolio;

identify and manage the market,

liquidity, credit and other risks

associated with merchant banking

investments; and monitor the terms,

amounts and types of transactions

between the financial holding company

and each company acquired under the

rule. The interim rule also required a

financial holding company to maintain

at a central location certain types of

records and supporting information

related to its merchant banking

investment activities, including records

that detailed the cost, carrying value,

market value, and performance of each

merchant banking investment.

Several commenters acknowledged

that companies engaged in making

merchant banking investments should

maintain strong internal controls and

recordkeeping policies. A number of

commenters also asked that the Board

and Secretary streamline the risk

management, recordkeeping or reporting

requirements in the interim rule. For

example, some commenters asserted

that the agencies should eliminate the

requirement that a financial holding

company maintain its merchant banking

records at a central location.

Commenters also urged that a financial

holding company be required to monitor

its relationships with a portfolio

company only where it has a substantial

interest in the portfolio company.

Several commenters requested that the

rule clarify the way the recordkeeping

requirements would apply to private

equity funds that are not controlled by

a financial holding company.

The Board recently issued supervisory

guidance that describes in detail the

internal controls and risk management

policies, procedures and systems that

the Federal Reserve expects bank

holding companies engaged in equity

investment activities to have and

maintain to conduct equity investment

activities in a safe and sound manner.22

The SR Letter provides, among other

things, that a financial holding company

engaged in merchant banking activities

should establish appropriate policies,

procedures and systems to manage all

elements of the investment decisionmaking and risk management process.

These policies, procedures and systems

include limits on the types and amounts

of merchant banking investments that

may be made; parameters governing

portfolio diversification; sound policies

governing the valuation and accounting

of investments; periodic audits of

compliance with established limits and

policies; and policies designed to ensure

that all investments in, and

relationships with, portfolio companies

comply with applicable law.

The SR Letter also requires a financial

holding company to monitor its lending

and other business relationships with a

company held under the merchant

banking authority to ensure that the

financial holding company’s aggregate

exposure to the company is reasonably

limited and that all transactions are on

reasonable terms. In addition, the SR

Letter requires a financial holding

company to maintain records that

appropriately document these policies,

procedures and systems and make such

records available to examiners.

For these reasons, the Board and the

Secretary have streamlined section

225.175 of the rule to identify the major

areas that must be addressed by the

internal policies and controls of a

financial holding company engaged in

making merchant banking investments.

In particular, the final rule requires a

financial holding company that makes

merchant banking investments to

establish and maintain policies,

procedures, records and systems

reasonably designed to conduct,

monitor and manage investment

activities and the associated risks in a

safe and sound manner. These policies,

procedures, records and systems must

be reasonably designed to—

• Monitor and assess the carrying

value, market value and performance of

each merchant banking investment and

the company’s aggregate merchant

banking investment portfolio;

• Identify and manage the market,

credit, concentration and other risks

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8479

associated with merchant banking

investments;

• Identify, monitor and assess the

terms, amounts and risks arising from

transactions and relationships

(including contingent fees or contingent

interests) with each company in which

the financial holding company holds an

interest under the rule;

• Ensure the maintenance of

corporate separateness between the

financial holding company and each

company in which the financial holding

company holds an interest under the

rule and protect the financial holding

company and its depository institution

subsidiaries from legal liability for the

operations conducted and financial

obligations of any such company; and

• Ensure compliance with the rule,

including the rule’s holding period,

routine management and operation, and

cross-marketing restrictions, and any

other applicable provisions of law

governing transactions and relationships

with companies in which the financial

holding company holds an interest

under the rule, such as fiduciary

principles and sections 23A and 23B of

the Federal Reserve Act.

The list of policies, procedures,

records and systems included in the

rule is intended to identify only some of

the most important elements of a sound

approach to monitoring merchant

banking investment activities. The SR

Letter covers these elements and

identifies other elements that a financial

holding company should have in place

to conduct merchant banking

investment activities in a safe and

sound manner–such as adequate

regulatory capital and appropriate

policies governing the public disclosure

of the company’s merchant banking

investments. Additional elements may

be needed to address the particular

approach that a financial holding

company takes to making merchant

banking investments.

If the financial holding company

controls a private equity fund or other

fund that makes merchant banking

investments, the financial holding

company must ensure that the fund has

the types of policies, procedures and

systems described in the rule for making

and monitoring the fund’s merchant

banking investments. Alternatively, the

financial holding company may ensure

that the private equity fund or other

fund is subject to the financial holding

company’s merchant banking policies,

procedures and systems. These

requirements do not apply if the

financial holding company does not

control the fund. Nevertheless, a

financial holding company must apply

its merchant banking policies,

procedures and systems to any

investment made by the company in any

fund that is controlled by an unaffiliated

entity.

The Board and the Secretary expect

that financial holding companies will be

able to satisfy the rule’s recordkeeping

requirements by using internal reports

and records that are prepared in the

ordinary course of making a merchant

banking investment or controlling a

private equity fund. Similarly, where a

financial holding company makes a

noncontrolling investment in a private

equity fund, it is anticipated that the

financial holding company would be

able to use information provided by the

fund’s adviser or sponsor to satisfy the

rule’s recordkeeping requirements.

The final rule does not require a

financial holding company to maintain

the records described in the rule at a

central location. Instead, a financial

holding company must be able to

identify and promptly make the

records—wherever located—available to

the Federal Reserve upon request.

In light of the potential risks

associated with making merchant

banking investments and the

importance of having in place

appropriate policies and systems to

monitor and manage such investment

activities, the Federal Reserve generally

will conduct a review of the investment

and risk management policies,

procedures and systems of a financial

holding company that makes merchant

banking investments within a short

period after the holding company

commences the activity. This review

may be conducted either off-site or onsite depending on the expected level

and complexity of the financial holding

company’s merchant banking

investments and the company’s

previous experience in making equity

investments under other legal

authorities. This review may be deferred

until the next regularly scheduled

inspection or examination if the

financial holding company has

significant experience in making equity

investments under pre-existing

authorities and the Federal Reserve has

recently reviewed the company’s

policies, procedures and systems for

managing and controlling the risks

associated with equity investment

activities.

Quarterly and Annual Reporting

Requirements

The interim rule established annual

and quarterly reporting requirements for

merchant banking investments. The

interim rule required financial holding

companies to annually provide

information concerning any merchant

banking investment held longer than

five years (or eight years in the case of

investments in or held through a private

equity fund) and aggregate data on the

cost, value, diversification and holding

periods of the company’s merchant

banking investments. The interim rule

also required financial holding

companies to provide certain other

aggregate data on merchant banking

investments on a quarterly basis. The

Board noted that it anticipated

developing forms that could be used to

comply with these annual and quarterly

reporting requirements.

Some commenters asserted that

requiring a financial holding company

to provide aggregate merchant banking

data on a quarterly basis would be too

burdensome and, because of the short

reporting period, might not reflect any

meaningful changes or trends in the

company’s merchant banking portfolio.

Other commenters argued that the

annual report should not require a

financial holding company to develop

or disclose its plans for divesting any

merchant banking investment held

longer than 8 years.

The Board and the Secretary continue

to believe that it is important to receive

at least annually information (including

anticipated exit strategies) concerning

merchant banking investments that have

been held for a significant period of

time and to receive at least quarterly

aggregate cost and valuation data on a

financial holding company’s merchant

banking investments. This information

is necessary and appropriate to allow

the Board to monitor a financial holding

company’s compliance with the holding

periods established by the GLB Act and

the rule and to monitor the potential

impact of merchant banking

investments on depository institution

subsidiaries of a financial holding

company.

The Board anticipates publishing

forms in the near future that may be

used by financial holding companies to

fulfill these annual and quarterly

reporting requirements. Accordingly,

the agencies have modified the rule to

require a financial holding company to

submit these reports to the appropriate

Federal Reserve Bank on such forms,

and at such times, as the may be

determined by the Board. The Board

will consider the public comments

received on the annual and quarterly

reporting requirements in connection

with issuing these forms.

Notice of Acquisitions

Section 4(k)(6) of the BHC Act

requires a financial holding company to

provide written notice to the Board

within 30 days after acquiring any

8480 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

23See 66 FR 400 (Jan. 3, 2001).

24See 65 FR 56,910 (Sept. 20, 2000); 65 FR 20,821

(April 18, 2000).

25For a domestic financial holding company, the

appropriate form is the FR Y–6A, which will soon

be replaced by the FR Y–10. For qualifying foreign

banking organizations, the appropriate form is the

FR Y–7A, which soon will be replaced by the FR

Y–10F.

26One commenter asserted that the GLB Act

authorizes the Board to grant exceptions to the

cross-marketing restrictions for arrangements that

meet the requirements of section 4(k)(5)(B) of the

BHC Act. The exemption described in section

4(k)(5)(B) is available only with respect to

investments that are held by insurance company

subsidiaries of a financial holding company under

section 4(k)(4)(I) and not to merchant banking

investments. See 12 U.S.C. 1843(k)(5)(B).

27See H.R. Rep. 106–74, 106th Cong., 1st Sess. at

122–23 (1999).

company under any authority granted in

section 4(k), which is the section that

authorizes merchant banking

investments. The interim rule provided

that a financial holding company is not

required to provide the Board with

notice under section 4(k)(6) of any

merchant banking investment if the

financial holding company has

previously notified the Board under

section 4(k)(6) that it has commenced

merchant banking investment activities

generally. The rule required, however,

that a financial holding company file a

post-transaction notice with the Board

within 30 days of making a merchant

banking investment if (1) the investment

represents more than 5 percent of the

voting shares, assets or ownership

interests of the company and (2) the

total cost of the investment to the

financial holding company exceeds the

lesser of 5 percent of the Tier 1 capital

of the financial holding company or

$200 million.

The final rule retains these posttransaction notice procedures. In these

circumstances, the Board believes

supervisory notice of the acquisition is

appropriate to allow the Board to

monitor the impact of the investment on

the financial holding company and any

future impact the large exposure to a

single company may have on the

financial resources of the financial

holding company. The procedures

included in the rule parallel those

contained in section 225.87 of the

Board’s Regulation Y and are included

here solely for the convenience of users.

The Board separately has considered the

comments submitted on these notice

requirements in connection with its

adoption of section 225.87.23

The Board, in separate rulemakings,

has adopted forms to be used by

financial holding companies in

providing the Board with notice of a

merchant banking or other transaction

under section 4(k)(6).24 Accordingly, the

agencies have amended the final rule to

require that any notice of a large

merchant banking investment be

provided on the appropriate form.25

Section 225.176—How Do the Statutory

Cross-Marketing and Sections 23A and

B Limitations Apply to Merchant

Banking Investments?

Cross-Marketing Restrictions

The GLB Act prohibits any depository

institution controlled by a financial

holding company from marketing or

offering, directly or through any

arrangement, any product or service of

a company held under section 4(k)(4)(H)

or allowing any product or service of the

depository institution to be offered or

marketed, directly or through any

arrangement, by or through any

company held under that section.

Section 225.175(a) of the interim rule

implemented these restrictions and

applied them to any subsidiary (other

than a financial subsidiary) of a

depository institution controlled by a

financial holding company.

Several commenters requested that

the agencies clarify the scope of the

rule’s cross-marketing prohibitions,

either by including a definition of what

constitutes ‘‘cross-marketing’’ or by

stating that certain types of activities are

not prohibited. A few commenters also

asserted that the rule’s cross-marketing

restrictions should not be applied to

subsidiaries of depository institutions

generally or to any subsidiary that a

depository institution is specifically

authorized by statute to control, such as

SBICs or Edge Act subsidiaries. Others

stated that the rule should not prohibit

a depository institution from marketing

the shares or other ownership interests

in a private equity fund to its

customers.26

The Act’s cross-marketing restrictions

apply to any depository institution

controlled by a financial holding

company. As noted above, U.S.

branches and agencies of a foreign bank

are considered depository institutions

for purposes of the rule. Accordingly, a

U.S. branch or agency of a foreign bank

may not cross-market the products or

services of a company that is owned or

controlled by the foreign bank or an

affiliate of the foreign bank under

section 4(k)(4)(H).

Depository institutions have long

been permitted to own or control socalled ‘‘operating subsidiaries’’ that

engage in activities permissible for the

parent depository institution on the

basis that the subsidiary is, in essence,

a department or division of the

institution. For this same reason, the

rule considers a depository institution

and a subsidiary of the depository

institution to be one and the same for

purposes of the cross-marketing

restrictions.

In certain instances, however,

Congress has specifically authorized

depository institutions to own or control

subsidiaries that may engage in

activities different than those

permissible for the parent institution.

The rule, therefore, does not apply the

cross-marketing restrictions to (1) a

financial subsidiary of a depository

institution held in accordance with

section 5136A of the Revised Statutes or

section 46 of the Federal Deposit

Insurance Act, (2) any company held by

an Edge or Agreement subsidiary

controlled pursuant to section 25 or 25A

of the Federal Reserve Act, or (3) any

company held by a SBIC controlled in

accordance with the Small Business

Investment Act.

The cross-marketing restrictions of the

GLB Act and rule do not apply to

nondepository affiliates of financial

holding companies. In addition, the rule

does not apply the cross-marketing

restrictions to companies in which the

financial holding company, directly or

indirectly, owns less than 5 percent of

the voting shares or ownership interests

since the holding company could own

such interests under section 4(c)(6) or

4(c)(7) of the BHC Act without being

subject to the GLB Act’s cross-marketing

restrictions.

The agencies also have amended the

rule to clarify the application of the

cross-marketing restrictions to interests

in or held through private equity funds.

A purpose of the cross-marketing

restrictions is to assist in maintaining

the separation between banking and

commerce.27 Since private equity funds,

by definition, may engage only in

investment activities for resale or other

disposition in accordance with the rule

and may not be engaged in

impermissible commercial activities, the

Board and the Secretary believe that

depository institutions (and their

subsidiaries) may offer or market the

shares or other ownership interests in a

private equity fund in which the

financial holding company has an

interest under the rule. Accordingly, the

agencies have amended the rule to

provide that section 225.176(a) does not

prohibit the sale, offer or marketing of

any interest in a private equity fund,

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8481

28Likewise, the cross-marketing restrictions

would not prohibit a depository institution

controlled by a financial holding company from

engaging in cross-marketing activities with a

company that is a co-investor with the financial

holding company in a portfolio company, so long

as those activities do not involve products or

services of the portfolio company.

29The final rule clarifies that the presumption

applies only where a financial holding company

owns or controls 15 percent or more of the total

equity of a portfolio company under section

4(k)(4)(H) and the rule. The Board notes, however,

that, under existing Board precedents, a financial

holding company may not own any shares of a

company in reliance on sections 4(c)(6) or 4(c)(7)

of the BHC Act where the company owns or

controls, in the aggregate under a combination of

authorities, more than 5 percent of any class of

voting securities of the company.

30See 12 U.S.C. 371c(3)(A).

31See 12 U.S.C. 371c(b)(3)(A)(i).

whether or not the fund is controlled by

a financial holding company.

The final rule also provides that the

cross-marketing restrictions do not

prohibit a depository institution

subsidiary of a financial holding

company from engaging in crossmarketing activities with a portfolio

company held by a private equity fund

that is owned but not controlled by the

financial holding company. Where the

financial holding company does not

control a private equity fund, shares

held by the fund generally are not

attributed to the financial holding

company.

The Act and the rule also do not

prohibit a depository institution or

subsidiary of a depository institution

from marketing its own products or

services—such as deposit, lending, and

advisory products or services—to a

portfolio company so long as the

portfolio company does not then market

those products or services to its

customers or others. In addition, the Act

and the rule do not prohibit a

depository institution from purchasing

the products or services of a portfolio

company—such as data processing

hardware, software or services—to

support the depository institution’s own

operations provided that the institution

does not, directly or indirectly or

through any arrangement, market the

portfolio company’s products or

services to the institution’s customers or

others.28

The agencies recognize that

companies currently may use a wide

variety of methods or arrangements to

market or offer their products with those

of other companies, and new methods

or arrangements for cross-marketing

may develop with advances in

technology, changes in consumer

shopping or purchasing habits, or other

developments. In light of these facts, the

agencies have not attempted in the rule

or in this preamble to identify every

type of arrangement that would, and

would not, be subject to the crossmarketing restrictions of the rule. The

agencies believe that questions

concerning the application of the rule’s

cross-marketing restrictions to particular

types of activities or arrangements are

handled most appropriately on a caseby-case basis, which would allow full

consideration of the particular

circumstances at issue in the context of

the purposes of the GLB Act.

Presumption of Control Under Sections

23A and 23B

Sections 23A and 23B of the Federal

Reserve Act impose specific

quantitative, qualitative and collateral

requirements on certain types of

transactions between an insured

depository institution and companies

that are under common control with the

insured depository institution. The GLB

Act includes a presumption that a

financial holding company or other

person controls a company for purposes

of sections 23A and 23B if the company

or other person, directly or indirectly, or

acting through one or more other

persons, owns or controls 15 percent or

more of the equity capital of the

company under section 4(k)(4)(H).

The interim rule included this

presumption and stated that a financial

holding company could rebut the

presumption by providing information

acceptable to the Board demonstrating

that the financial holding company did

not control the company.29 Several

commenters requested that the agencies

identify in the rule circumstances that

would be sufficient to rebut this

presumption of control. For example,

some commenters suggested that the

presumption should be rebutted if the

financial holding company had no more

than one director interlock with the

portfolio company, or if an unaffiliated

investor (or two or more unaffiliated

investors acting in concert) owned or

controlled a larger equity interest in the

portfolio company than the financial

holding company.

In light of these comments, the

agencies have amended the rule to

identify three situations in which the

GLB Act’s presumption of control will

be considered rebutted. In each

situation the financial holding company

is assumed to own more than 15 percent

of the total equity of the portfolio

company (thereby triggering the

statutory presumption) and less than 25

percent of any class of voting securities

of the portfolio company (thereby not

meeting the statutory definition of

control). In particular, the rule provides

that, absent evidence to the contrary, a

financial holding company will not be

presumed to control a portfolio

company in any of the following

situations—

• No officer, director or employee of

the financial holding company serves as

a director, trustee or general partner (or

individual exercising similar functions)

of the portfolio company;

• A person that is not affiliated or

associated with the financial holding

company owns or controls a greater

percentage of the equity capital of the

portfolio company than the financial

holding company and no more than one

officer or employee of the holding

company serves as a director or trustee

(or individuals exercising similar

functions) of the portfolio company; or

• A person that is not affiliated or

associated with the financial holding

company owns or controls more than 50

percent of the voting shares of the

portfolio company and officers and

employees of the financial holding

company do not constitute a majority of

the directors or trustees (or individuals

exercising similar functions) of the

portfolio company.

These safe harbors do not require

Board review or approval under the

provisions allowing rebuttal of the

presumptions. Moreover, the situations

identified in the rule are not intended

to be a complete list of circumstances in

which the presumption may be

rebutted, and the rule permits a

financial holding company to submit

evidence that would support rebuttal of

the presumption in other circumstances.

The agencies note that the

presumption of control in section

225.176(b) is independent from the

general definition of control in section

23A of the Federal Reserve Act.30

Accordingly, under the statute, a

portfolio company is per se an affiliate

of any insured depository institution

subsidiary of a financial holding

company if the financial holding

company owns more than 25 percent of

a class of voting securities of the

portfolio company, even if the financial

holding company owns or controls less

than 15 percent of the portfolio

company’s total equity or is within one

of the safe harbors contained in the final

rule.31

A financial holding company

generally is considered indirectly to

own or control only those shares or

other ownership interests that are

owned or controlled by a subsidiary of

the financial holding company.

Accordingly, the rule clarifies that, for

purposes of applying the presumption

8482 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

32For purposes of applying the restrictions of

sections 23A and 23B to U.S. branches and agencies

of foreign banks, the ‘‘capital stock and surplus’’ of

the U.S. branch or agency is determined by

reference to the capital of the foreign bank as

calculated under its home country capital

standards.

of control described above, a financial

holding company that has an

investment in a private equity fund will

not be considered indirectly to own the

equity capital of a portfolio company

held by the fund unless the financial

holding company controls the private

equity fund. For example, if a financial

holding company has a noncontrolling

investment in a private equity fund that,

in turn, owns 20 percent of the total

equity of a portfolio company, the

portfolio company is not presumed to be

an affiliate of the insured depository

institution subsidiaries of the financial

holding company under section

225.176(b)(1). On the other hand, if a

financial holding company acts as

general partner of a private equity fund

and, thus, controls the fund, and the

private equity fund owns or controls

more than 15 percent of the total equity

of any portfolio company, the portfolio

company is presumed to be an affiliate

of the insured depository institution

subsidiaries of the financial holding

company under section 225.176(b)(1).

The rule also applies sections 23A

and 23B to covered transactions

between a U.S. branch or agency of a

foreign bank and (1) any portfolio

company controlled by the foreign bank

or an affiliate of the foreign bank, and

(2) any company controlled by the

foreign bank or an affiliate where the

company is engaged in making

merchant banking investments if the

proceeds of the covered transaction are

used for the purpose of funding the

company’s merchant banking activities

under this subpart. The presumption of

control and exceptions to this

presumption described above also apply

to a foreign bank or affiliate that makes

merchant banking investments in the

same manner the presumption and

exceptions apply to domestic financial

holding companies.

A few commenters contended that the

Board should not apply sections 23A

and 23B to covered transactions

involving a U.S. branch or agency of a

foreign bank. These commenters noted

that U.S. branches and agencies do not

hold federally insured deposits and

contended that application of sections

23A and 23B is not necessary to ensure

competitive equality and that any

potential safety and soundness concerns

may be addressed by the appropriate

home country supervisor of the foreign

bank.

The Board and the Secretary believe

application of sections 23A and 23B to

covered transactions between a U.S.

branch or agency of a foreign bank and

portfolio companies held by the foreign

bank or an affiliate under the merchant

banking authority, and companies

engaged in making merchant banking

investments, is appropriate to ensure

competitive equity and safe and sound

banking. Furthermore, the rule only

restricts transactions by a foreign bank’s

branches and agencies with portfolio

companies and with affiliated

companies that are actually engaged in

making merchant banking

investments.32 It does not restrict

otherwise permissible lending to

affiliated companies where the proceeds

of such lending would not be used by

these companies to make, or fund the

making of, merchant banking

investments under this subpart.

Moreover, it does not restrict

transactions between the U.S. branch or

agency and its parent foreign bank.

D. Regulatory Flexibility Act Analysis

In accordance with section 4(a) of the

Regulatory Flexibility Act (5 U.S.C.

604(a)), the Board must publish a final

regulatory flexibility analysis with this

rulemaking. The rule implements

provisions of section 103 of the GLB Act

that allow entities that have become

financial holding companies to make

merchant banking investments. Because

the rule establishes guidelines for a

newly authorized activity, the rule will

affect only merchant banking activities

that are newly authorized under the

GLB Act.

The statute’s limits apply to all

financial holding companies, regardless

of size, that are engaged in merchant

banking activities. Similarly, the final

rule directs each financial holding

company, regardless of size, that is

engaged in merchant banking activity to

establish necessary internal controls,

including recordkeeping procedures,

and provide reports to the appropriate

Reserve Bank as the Board may require.

The internal controls, reporting and

recordkeeping requirements that the

rule establishes are necessary to ensure

that the new activities are conducted in

a safe and sound manner that does not

adversely affect affiliated depository

institutions, to enable the Board to

execute properly its supervisory

function and to ensure compliance by

financial holding companies with the

limitations that the GLB Act imposes on

merchant banking activities. The Board

believes that the information that

financial holding companies are

required to submit, pursuant to the final

rule, will be similar to that appearing in

routine reports to senior management,

third-party investors, or other regulatory

agencies (including the Securities and

Exchange Commission), or that will be

part of materials that an organization

prepares and retains in the normal

conduct of its investment activities.

The ability of financial holding

companies to participate in the

merchant banking business will likely

enhance the overall efficiency and

competitiveness of these institutions in

the market for corporate financial

services. In promulgating the interim

rule, the Board specifically sought

comment on the likely burden that the

rule would impose on financial holding

companies that engage in merchant

banking activities. A few comments

argued that the recordkeeping and

reporting requirements of the rule were

burdensome and unnecessary given

other forms of regulatory supervision to

which financial holding companies

would remain subject. As explained

above, the final rule has been

streamlined in an attempt to reduce

unnecessary burden. Other comments

argued that financial holding companies

will require a transition period in order

to comply with the reporting and

recordkeeping requirements of the rule.

In this regard, the annual reports

proposed under the rule relate only to

investments held for a period of

approximately five years, which,

because the authority to make these

investments is new, has the effect of

phasing in the annual reporting

requirement. Moreover, none of the

comments addressed how the interim

rule’s requirements would substantially

increase the regulatory burden for

financial holding companies given that

most of the data that the interim rule

required is found in reports that

financial holding companies make to

their investors or to other regulatory

agencies, or maintain for their own

internal use.

E. Executive Order 12866

Determination

The Department of the Treasury has

determined that this final rule does not

constitute a ‘‘significant regulatory

action’’ for purposes of Executive Order

12866.

F. Administrative Procedure Act

The provisions of the rule are

effective on February 15, 2001 on a final

basis. In accordance with requirements

of 5 U.S.C. 553, the interim rule set forth

procedures to implement statutory

changes that had become effective on

March 11, 2000. The interim rule itself

became effective on March 17, 2000.

The Board and the Secretary sought

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8483

public comment on all aspects of the

interim rule and have amended the rule

as appropriate after reviewing the

comments.

Subject to certain exceptions, 12

U.S.C. 4802(b)(1) provides that new

regulations and amendments to

regulations prescribed by a federal

banking agency that impose additional

reporting, disclosure, or other new

requirements on an insured depository

institution must take effect on the first

day of a calendar quarter that begins on

or after the date on which the

regulations are published in final form.

The final rule imposes no additional

reporting, disclosure, or other new

requirements on an insured depository

institution because the new activities

that the rule governs cannot be

conducted by an insured depository

institution. For this reason, section

4802(b)(1) does not apply to this

rulemaking.

G. Paperwork Reduction Act

Board: In accordance with section

3506 of the Paperwork Reduction Act of

1995 (44 U.S.C. Ch. 35; 5 CFR 1320

Appendix A.1), the Board reviewed the

final rule under the authority delegated

to the Board by the Office of

Management and Budget.

Most of the collection of information

requirements in the final rule are found

in 12 CFR 225.171, 225.172, 225.173,

and 225.175. This information is

required to evidence compliance with

the requirements of Title I of the GLB

Act (Pub. L. 106–102, 113 Stat. 1338

(1999)), which amends section 4 of the

Bank Holding Company Act (12 U.S.C.

1843), and to allow the Board to

exercise properly its supervisory

responsibility for financial holding

companies. The respondents are

financial holding companies that choose

to engage in merchant banking

activities.

The final rule requires that financial

holding companies submit reports to the

Reserve Bank that the Board may

prescribe (12 CFR 225.175(b)). The

Board expects to publish a separate

notice to issue reporting forms that may

be used to comply with reporting

requirements. The burden associated

with these information collections will

be addressed at that time.

In addition, the final rule requires that

a financial holding company file a

notice with the Reserve Bank within 30

days of making a large merchant

banking investment (see 12 CFR

225.175(c)(2)). This requirement is

imposed by statute, and the agencies

have minimized the information that

must be filed to fulfill this statutory

requirement. This notice requirement is

also codified in section 225.87(b)(4) of

the Board’s Regulation Y and is

included in this rule solely for

convenience. The regulatory burden

associated with this notice was

addressed in the final rule

implementing provisions of the GrammLeach-Bliley Act that establish certain

eligibility requirements for financial

holding companies (see 66 FR 400).

In addition, the rule allows a financial

holding company to seek relief from the

holding period limits imposed by the

rule by filing a request and supporting

documentation with the Board (12 CFR

225.172(b) and 225.173(c)). The agency

form number for these requests will be

FR 4019. Information may also be

submitted in letter form. The Board

expects to receive very few of these

notices and requests. The Board

estimates that approximately 450

financial holding companies will be

engaged in merchant banking activities

within the first year of promulgation of

the final rule. Of these financial holding

companies, the Board believes that a

high estimate of the potential number of

notices and requests that would be filed

under these various requirements

during a single year is 100. The Board

estimates that these companies will

spend approximately 1 hour to prepare

these filings, resulting in an estimated

annual burden of 100 hours. Based on

a rate of $50 per hour, the annual cost

to the public will have been $5,000.

The rule also requires a financial

holding company to provide notice to

the Board prior to routinely managing or

operating a portfolio company for more

than 9 months (12 CFR 225.171(e)(3)).

These notices, which may be in letter

form, should contain the information

described above under section 225.171.

The agency form number for these

notices also will be FR 4019. The Board

estimates receiving 25 notices during a

single year and that financial holding

companies will spend approximately 1

hour to prepare these notices, resulting

in an estimated annual burden of 25

hours. Based on a rate of $50 per hour,

the annual cost to the public would be

$1,250.

The final rule also requires that a

financial holding company engaged in

merchant banking activities establish

and maintain certain policies,

procedures, and systems to

appropriately monitor and manage its

merchant banking activities and

maintain certain records relating to the

company’s merchant banking activities

(12 CFR 225.175(a), 225.171(a)(4)). The

Federal Reserve believes that most of

these internal control and recordkeeping

requirements are consistent with those

established and maintained by

organizations in the normal course of

conducting a merchant banking

business. The Board estimates that the

450 financial holding companies will

spend approximately 50 hours in

complying with these internal control

and recordkeeping requirements,

resulting in an estimated annual burden

of 22,500 hours. Based on a rate of $50

per hour, the annual cost to the public

would be $1.13 million.

In issuing the interim rule, the

Federal Reserve specifically requested

comment on the accuracy of its original

burden estimates. No comments

challenged the accuracy of those

estimates beyond asserting that the

recordkeeping requirements of the

interim rule would prove burdensome

to financial holding companies. The

Board has streamlined many of the

recordkeeping and reporting provisions

of the interim rule and made them part

of the Board’s supervisory process.

The Federal Reserve may not conduct

or sponsor, and an organization is not

required to respond to, an information

collection unless the Board has

displayed a currently valid OMB control

number. The OMB control number for

these information collections is 7100–

0292. A financial holding company may

request confidentiality for the

information contained in these

information collections pursuant to

sections 522(b)(4) and 522(b)(6) of the

Freedom of Information Act (5 U.S.C.

552(b)(4) and (b)(6)).

The Federal Reserve has a continuing

interest in the public’s opinions of our

collections of information. At any time,

comments regarding the burden

estimate, or any other aspect of this

collection of information, including

suggestions for reducing the burden,

may be sent to: Secretary, Board of

Governors of the Federal Reserve

System, 20th and C Streets, NW.,

Washington, DC 20551; and to the

Office of Management and Budget,

Paperwork Reduction Project (7100–

0292), Washington, DC 20503.

Treasury: The collection of

information contained in this regulation

has been reviewed under the

requirements of the Paperwork

Reduction Act (44 U.S.C. 3507(j)) and,

pending receipt and evaluation of

public comments, approved by the

Office of Management and Budget

(OMB) under control number 1505–

0182. An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless it displays a valid control

number assigned by OMB.

Comments concerning the collection

of information should be directed to

OMB, Attention: Desk Officer for the

8484 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

Department of the Treasury, Office of

Information and Regulatory Affairs,

Washington, DC., 20503, with copies to

Gary Sutton, Senior Banking Counsel,

Office of General Counsel, 1500

Pennsylvania Avenue NW, Room 2014,

Washington, DC. 20220. Any such

comments should be submitted not later

than April 2, 2001. Comments are

specifically requested concerning:

whether the proposed collection of

information is necessary for the proper

performance of the functions of the

Secretary, including whether the

information will have practical utility;

the accuracy of the estimated burden

associated with the proposed collection

of information (see below); how to

enhance the quality, utility, and clarity

of the information to be collected; how

to minimize the burden of complying

with the proposed collection of

information, including the application

of automated collection techniques or

other forms of information technology;

and estimates of capital or start-up costs

and costs of operation, maintenance,

and purchase of services to provide

information.

The collection of information in this

regulation is in 12 CFR 1500.6. This

information is required in order that

financial holding companies that

conduct merchant banking activities do

so in a safe and sound manner

consistent with the requirements of the

regulation.

Estimated total annual recordkeeping

burden: 22,500 hours.

Estimated average annual burden

hours per recordkeeper: 50 hours

Estimated number of respondents:

450.

H. Use of ‘‘Plain Language’’

Section 722 of the GLB Act requires

the Board to use ‘‘plain language’’ in all

proposed and final rules published after

January 1, 2000. The Board invited

comments about how to make the rule

easier to understand and, in doing so,

posed the following questions:

(1) Has the Board organized the

material in an effective manner? If not,

how could the material be better

organized?

(2) Are the terms of the rule clearly

stated? If not, how could the terms be

more clearly stated?

(3) Does the rule contain technical

language or jargon that is unclear? If so,

which language requires clarification?

(4) Would a different format (with

respect to the grouping and order of

sections and use of headings) make the

rule easier to understand? If so, what

changes to the format would make the

rule easier to understand?

(5) Would increasing the number of

sections (and making each section

shorter) clarify the rule? If so, which

portions of the rule should be changed

in this respect?

(6) What additional changes would

make the rule easier to understand?

The Board also solicited comment

about whether including factual

examples in the rule, in order to

illustrate its terms, is appropriate. The

Board noted that creating safe harbors in

the rule may generate certain problems

over time due to changes in technology

or business practices and asked whether

alternatives exist that the Board should

consider to illustrate the terms in the

rule.

One comment questioned the use of

an interrogatory format for the headings

accompanying each section of the rule

but stated that the rule generally

complied with the requirements and

purpose of the statute.

The Board has streamlined and

reorganized parts of the rule in an effort

to make the rule more understandable

and believes that the final rule is written

plainly and clearly.

List of Subjects

12 CFR Part 225

Administrative practice and

procedure, Banks, Banking, Federal

Reserve System, Holding companies,

Reporting and recordkeeping

requirements, Securities.

12 CFR Part 1500

Administrative practice and

procedure, Banks, Banking, Holding

companies.

Federal Reserve System

12 CFR Chapter II

Authority and Issuance

For the reasons set forth in the

preamble, the Board of Governors of the

Federal Reserve System amends part

225 of Chapter II, Title 12 of the Code

of Federal Regulations as follows:

PART 225—BANK HOLDING

COMPANIES AND CHANGE IN BANK

CONTROL (REGULATION Y)

1. The authority citation for part 225

continues 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), 2903, 2905, 3106, 3108,

3310, 3331–3351, 3907, and 3909.

2. Section 225.1(c)(10) is revised to

read as follows:

§ 225.1 Authority, purpose, and scope.

* * * * *

(c) * * *

(10) Subpart J governs the conduct of

merchant banking investment activities

by financial holding companies as

permitted under section 4(k)(4)(H) of the

Bank Holding Company Act (12 U.S.C.

1843(k)(4)(H)).

* * * * *

3. Subpart J, is revised to read as

follows:

Subpart J—Merchant Banking Investments

Sec.

225.170 What type of investments are

permitted by this subpart, and under

what conditions may they be made?

225.171 What are the limitations on

managing or operating a portfolio

company held as a merchant banking

investment?

225.172 What are the holding periods

permitted for merchant banking

investments?

225.173 How are investments in private

equity funds treated under this subpart?

225.174 What aggregate thresholds apply to

merchant banking investments?

225.175 What risk management, record

keeping and reporting policies are

required to make merchant banking

investments?

225.176 How do the statutory cross

marketing and sections 23A and B

limitations apply to merchant banking

investments?

225.177 Definitions.

Subpart J—Merchant Banking

Investments

§ 225.170 What type of investments are

permitted by this subpart, and under what

conditions may they be made?

(a) What types of investments are

permitted by this subpart? Section

4(k)(4)(H) of the Bank Holding Company

Act (12 U.S.C. 1843(k)(4)(H)) and this

subpart authorize a financial holding

company, directly or indirectly and as

principal or on behalf of one or more

persons, to acquire or control any

amount of shares, assets or ownership

interests of a company or other entity

that is engaged in any activity not

otherwise authorized for the financial

holding company under section 4 of the

Bank Holding Company Act. For

purposes of this subpart, shares, assets

or ownership interests acquired or

controlled under section 4(k)(4)(H) and

this subpart are referred to as ‘‘merchant

banking investments.’’ A financial

holding company may not directly or

indirectly acquire or control any

merchant banking investment except in

compliance with the requirements of

this subpart.

(b) Must the investment be a bona fide

merchant banking investment? The

acquisition or control of shares, assets or

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8485

ownership interests under this subpart

is not permitted unless it is part of a

bona fide underwriting or merchant or

investment banking activity.

(c) What types of ownership interests

may be acquired? Shares, assets or

ownership interests of a company or

other entity include any debt or equity

security, warrant, option, partnership

interest, trust certificate or other

instrument representing an ownership

interest in the company or entity,

whether voting or nonvoting.

(d) Where in a financial holding

company may merchant banking

investments be made? A financial

holding company and any subsidiary

(other than a depository institution or

subsidiary of a depository institution)

may acquire or control merchant

banking investments. A financial

holding company and its subsidiaries

may not acquire or control merchant

banking investments on behalf of a

depository institution or subsidiary of a

depository institution.

(e) May assets other than shares be

held directly? A financial holding

company may not under this subpart

acquire or control assets, other than debt

or equity securities or other ownership

interests in a company, unless:

(1) The assets are held by or promptly

transferred to a portfolio company;

(2) The portfolio company maintains

policies, books and records, accounts,

and other indicia of corporate,

partnership or limited liability

organization and operation that are

separate from the financial holding

company and limit the legal liability of

the financial holding company for

obligations of the portfolio company;

and

(3) The portfolio company has

management that is separate from the

financial holding company to the extent

required by § 225.171.

(f) What type of affiliate is required for

a financial holding company to make

merchant banking investments? A

financial holding company may not

acquire or control merchant banking

investments under this subpart unless

the financial holding company qualifies

under at least one of the following

paragraphs:

(1) Securities affiliate. The financial

holding company is or has an affiliate

that is registered under the Securities

Exchange Act of 1934 (15 U.S.C. 78c,

78o, 78o–4) as:

(i) A broker or dealer; or

(ii) A municipal securities dealer,

including a separately identifiable

department or division of a bank that is

registered as a municipal securities

dealer.

(2) Insurance affiliate with an

investment adviser affiliate. The

financial holding company controls:

(i) An insurance company that is

predominantly engaged in underwriting

life, accident and health, or property

and casualty insurance (other than

credit-related insurance), or providing

and issuing annuities; and

(ii) A company that:

(A) Is registered with the Securities

and Exchange Commission as an

investment adviser under the

Investment Advisers Act of 1940 (15

U.S.C. 80b–1 et seq.); and

(B) Provides investment advice to an

insurance company.

§ 225.171 What are the limitations on

managing or operating a portfolio company

held as a merchant banking investment?

(a) May a financial holding company

routinely manage or operate a portfolio

company? Except as permitted in

paragraph (e) of this section, a financial

holding company may not routinely

manage or operate any portfolio

company.

(b) When does a financial holding

company routinely manage or operate a

company? 

(1) Examples of routine management

or operation.—(i) Executive officer

interlocks at the portfolio company. A

financial holding company routinely

manages or operates a portfolio

company if any director, officer or

employee of the financial holding

company serves as or has the

responsibilities of an executive officer of

the portfolio company.

(ii) Interlocks by executive officers of

the financial holding company.—

(A) Prohibition. A financial holding

company routinely manages or operates

a portfolio company if any executive

officer of the financial holding company

serves as or has the responsibilities of

an officer or employee of the portfolio

company.

(B) Definition. For purposes of

paragraph (b)(1)(ii)(A) of this section,

the term ‘‘financial holding company’’

includes the financial holding company

and only the following subsidiaries of

the financial holding company:

(1) A securities broker or dealer

registered under the Securities

Exchange Act of 1934;

(2) A depository institution;

(3) An affiliate that engages in

merchant banking activities under this

subpart or insurance company

investment activities under section

4(k)(4)(I) of the Bank Holding Company

Act (12 U.S.C. 1843(k)(4)(I));

(4) A small business investment

company (as defined in section 302(b) of

the Small Business Investment Act of

1958 (15 U.S.C. 682(b)) controlled by

the financial holding company or by any

depository institution controlled by the

financial holding company; and

(5) Any other affiliate that engages in

significant equity investment activities

that are subject to a special capital

charge under the capital adequacy rules

or guidelines of the Board.

(iii) Covenants regarding ordinary

course of business. A financial holding

company routinely manages or operates

a portfolio company if any covenant or

other contractual arrangement exists

between the financial holding company

and the portfolio company that would

restrict the portfolio company’s ability

to make routine business decisions,

such as entering into transactions in the

ordinary course of business or hiring

officers or employees other than

executive officers.

(2) Presumptions of routine

management or operation. A financial

holding company is presumed to

routinely manage or operate a portfolio

company if:

(i) Any director, officer, or employee

of the financial holding company serves

as or has the responsibilities of an

officer (other than an executive officer)

or employee of the portfolio company;

or

(ii) Any officer or employee of the

portfolio company is supervised by any

director, officer, or employee of the

financial holding company (other than

in that individual’s capacity as a

director of the portfolio company).

(c) How may a financial holding

company rebut a presumption that it is

routinely managing or operating a

portfolio company? A financial holding

company may rebut a presumption that

it is routinely managing or operating a

portfolio company under paragraph

(b)(2) of this section by presenting

information to the Board demonstrating

to the Board’s satisfaction that the

financial holding company is not

routinely managing or operating the

portfolio company.

(d) What arrangements do not involve

routinely managing or operating a

portfolio company?—(1) Director

representation at portfolio companies. A

financial holding company may select

any or all of the directors of a portfolio

company or have one or more of its

directors, officers, or employees serve as

directors of a portfolio company if:

(i) The portfolio company employs

officers and employees responsible for

routinely managing and operating the

company; and

(ii) The financial holding company

does not routinely manage or operate

the portfolio company, except as

8486 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

permitted in paragraph (e) of this

section.

(2) Covenants or other provisions

regarding extraordinary events. A

financial holding company may, by

virtue of covenants or other written

agreements with a portfolio company,

restrict the ability of the portfolio

company, or require the portfolio

company to consult with or obtain the

approval of the financial holding

company, to take actions outside of the

ordinary course of the business of the

portfolio company. Examples of the

types of actions that may be subject to

these types of covenants or agreements

include, but are not limited to, the

following:

(i) The acquisition of significant assets

or control of another company by the

portfolio company or any of its

subsidiaries;

(ii) Removal or selection of an

independent accountant or auditor or

investment banker by the portfolio

company;

(iii) Significant changes to the

business plan or accounting methods or

policies of the portfolio company;

(iv) Removal or replacement of any or

all of the executive officers of the

portfolio company;

(v) The redemption, authorization or

issuance of any equity or debt securities

(including options, warrants or

convertible shares) of the portfolio

company or any borrowing by the

portfolio company outside of the

ordinary course of business;

(vi) The amendment of the articles of

incorporation or by-laws (or similar

governing documents) of the portfolio

company; and

(vii) The sale, merger, consolidation,

spin-off, recapitalization, liquidation,

dissolution or sale of substantially all of

the assets of the portfolio company or

any of its significant subsidiaries.

(3) Providing advisory and

underwriting services to, and having

consultations with, a portfolio company.

A financial holding company may:

(i) Provide financial, investment and

management consulting advice to a

portfolio company in a manner

consistent with and subject to any

restrictions on such activities contained

in §§ 225.28(b)(6) or 225.86(b)(1) of this

part (12 CFR 225.28(b)(6) and

225.86(b)(1));

(ii) Provide assistance to a portfolio

company in connection with the

underwriting or private placement of its

securities, including acting as the

underwriter or placement agent for such

securities; and

(iii) Meet with the officers or

employees of a portfolio company to

monitor or provide advice with respect

to the portfolio company’s performance

or activities.

(e) When may a financial holding

company routinely manage or operate a

portfolio company?—(1) Special

circumstances required. A financial

holding company may routinely manage

or operate a portfolio company only

when intervention by the financial

holding company is necessary or

required to obtain a reasonable return

on the financial holding company’s

investment in the portfolio company

upon resale or other disposition of the

investment, such as to avoid or address

a significant operating loss or in

connection with a loss of senior

management at the portfolio company.

(2) Duration Limited. A financial

holding company may routinely manage

or operate a portfolio company only for

the period of time as may be necessary

to address the cause of the financial

holding company’s involvement, to

obtain suitable alternative management

arrangements, to dispose of the

investment, or to otherwise obtain a

reasonable return upon the resale or

disposition of the investment.

(3) Notice required for extended

involvement. A financial holding

company may not routinely manage or

operate a portfolio company for a period

greater than nine months without prior

written notice to the Board.

(4) Documentation required. A

financial holding company must

maintain and make available to the

Board upon request a written record

describing its involvement in routinely

managing or operating a portfolio

company.

(f) May a depository institution or its

subsidiary routinely manage or operate

a portfolio company?—(1) In general. A

depository institution and a subsidiary

of a depository institution may not

routinely manage or operate a portfolio

company in which an affiliated

company owns or controls an interest

under this subpart.

(2) Definition applying provisions

governing routine management or

operation. For purposes of this section

other than paragraph (e) and for

purposes of § 225.173(d), a financial

holding company includes a depository

institution controlled by the financial

holding company and a subsidiary of

such a depository institution.

(3) Exception for certain subsidiaries

of depository institutions. For purposes

of paragraph (e) of this section, a

financial holding company includes a

financial subsidiary held in accordance

with section 5136A of the Revised

Statutes (12 U.S.C. 24a) or section 46 of

the Federal Deposit Insurance Act (12

U.S.C. 1831w), and a subsidiary that is

a small business investment company

and that is held in accordance with the

Small Business Investment Act (15

U.S.C. 661 et seq.), and such a

subsidiary may, in accordance with the

limitations set forth in this section,

routinely manage or operate a portfolio

company in which an affiliated

company owns or controls an interest

under this subpart.

§ 225.172 What are the holding periods

permitted for merchant banking

investments?

(a) Must investments be made for

resale? A financial holding company

may own or control shares, assets and

ownership interests pursuant to this

subpart only for a period of time to

enable the sale or disposition thereof on

a reasonable basis consistent with the

financial viability of the financial

holding company’s merchant banking

investment activities.

(b) What period of time is generally

permitted for holding merchant banking

investments?—(1) In general. Except as

provided in this section or § 225.173, a

financial holding company may not,

directly or indirectly, own, control or

hold any share, asset or ownership

interest pursuant to this subpart for a

period that exceeds 10 years.

(2) Ownership interests acquired from

or transferred to companies held under

this subpart. For purposes of paragraph

(b)(1) of this section, shares, assets or

ownership interests—

(i) Acquired by a financial holding

company from a company in which the

financial holding company held an

interest under this subpart will be

considered to have been acquired by the

financial holding company on the date

that the share, asset or ownership

interest was acquired by the company;

and

(ii) Acquired by a company from a

financial holding company will be

considered to have been acquired by the

company on the date that the share,

asset or ownership interest was acquired

by the financial holding company if—

(A) The financial holding company

held the share, asset, or ownership

interest under this subpart; and

(B) The financial holding company

holds an interest in the acquiring

company under this subpart.

(3) Interests previously held by a

financial holding company under

limited authority. For purposes of

paragraph (b)(1) of this section, any

shares, assets, or ownership interests

previously owned or controlled, directly

or indirectly, by a financial holding

company under any other provision of

the Federal banking laws that imposes

a limited holding period will if acquired

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8487

under this subpart be considered to

have been acquired by the financial

holding company under this subpart on

the date the financial holding company

first acquired ownership or control of

the shares, assets or ownership interests

under such other provision of law. For

purposes of this paragraph (b)(3), a

financial holding company includes a

depository institution controlled by the

financial holding company and any

subsidiary of such a depository

institution.

(4) Approval required to hold interests

held in excess of time limit. A financial

holding company may seek Board

approval to own, control or hold shares,

assets or ownership interests of a

company under this subpart for a period

that exceeds the period specified in

paragraph (b)(1) of this section. A

request for approval must:

(i) Be submitted to the Board at least

90 days prior to the expiration of the

applicable time period;

(ii) Provide the reasons for the

request, including information that

addresses the factors in paragraph (b)(5)

of this section; and

(iii) Explain the financial holding

company’s plan for divesting the shares,

assets or ownership interests.

(5) Factors governing Board

determinations. In reviewing any

proposal under paragraph (b)(4) of this

section, the Board may consider all the

facts and circumstances related to the

investment, including:

(i) The cost to the financial holding

company of disposing of the investment

within the applicable period;

(ii) The total exposure of the financial

holding company to the company and

the risks that disposing of the

investment may pose to the financial

holding company;

(iii) Market conditions;

(iv) The nature of the portfolio

company’s business;

(v) The extent and history of

involvement by the financial holding

company in the management and

operations of the company; and

(vi) The average holding period of the

financial holding company’s merchant

banking investments.

(6) Restrictions applicable to

investments held beyond time period. A

financial holding company that directly

or indirectly owns, controls or holds

any share, asset or ownership interest of

a company under this subpart for a total

period that exceeds the period specified

in paragraph (b)(1) of this section

must—

(i) For purposes of determining the

financial holding company’s regulatory

capital, apply to the financial holding

company’s adjusted carrying value of

such shares, assets, or ownership

interests a capital charge determined by

the Board that must be:

(A) Higher than the maximum

marginal Tier 1 capital charge

applicable under the Board’s capital

adequacy rules or guidelines (see 12

CFR 225 Appendix A) to merchant

banking investments held by that

financial holding company; and

(B) In no event less than 25 percent

of the adjusted carrying value of the

investment; and

(ii) Abide by any other restrictions

that the Board may impose in

connection with granting approval

under paragraph (b)(4) of this section.

§ 225.173 How are investments in private

equity funds treated under this subpart?

(a) What is a private equity fund? For

purposes of this subpart, a ‘‘private

equity fund’’ is any company that:

(1) Is formed for the purpose of and

is engaged exclusively in the business of

investing in shares, assets, and

ownership interests of financial and

nonfinancial companies for resale or

other disposition;

(2) Is not an operating company;

(3) No more than 25 percent of the

total equity of which is held, owned or

controlled, directly or indirectly, by the

financial holding company and its

directors, officers, employees and

principal shareholders;

(4) Has a maximum term of not more

than 15 years; and

(5) Is not formed or operated for the

purpose of making investments

inconsistent with the authority granted

under section 4(k)(4)(H) of the Bank

Holding Company Act (12 U.S.C.

1843(k)(4)(H)) or evading the limitations

governing merchant banking

investments contained in this subpart.

(b) What form may a private equity

fund take? A private equity fund may be

a corporation, partnership, limited

liability company or other type of

company that issues ownership interests

in any form.

(c) What is the holding period

permitted for interests in private equity

funds?

(1) In general. A financial holding

company may own, control or hold any

interest in a private equity fund under

this subpart and any interest in a

portfolio company that is owned or

controlled by a private equity fund in

which the financial holding company

owns or controls any interest under this

subpart for the duration of the fund, up

to a maximum of 15 years.

(2) Request to hold interest for longer

period. A financial holding company

may seek Board approval to own,

control or hold an interest in or held

through a private equity fund for a

period longer than the duration of the

fund in accordance with § 225.172(b) of

this subpart.

(3) Application of rules. The rules

described in § 225.172(b)(2) and (3)

governing holding periods of interests

acquired, transferred or previously held

by a financial holding company apply to

interests in, held through, or acquired

from a private equity fund.

(d) How do the restrictions on routine

management and operation apply to

private equity funds and investments

held through a private equity fund?—(1)

Portfolio companies held through a

private equity fund. A financial holding

company may not routinely manage or

operate a portfolio company that is

owned or controlled by a private equity

fund in which the financial holding

company owns or controls any interest

under this subpart, except as permitted

under § 225.171(e).

(2) Private equity funds controlled by

a financial holding company. A private

equity fund that is controlled by a

financial holding company may not

routinely manage or operate a portfolio

company, except as permitted under

§ 225.171(e).

(3) Private equity funds that are not

controlled by a financial holding

company. A private equity fund may

routinely manage or operate a portfolio

company so long as no financial holding

company controls the private equity

fund or as permitted under § 225.171(e).

(4) When does a financial holding

company control a private equity fund?

A financial holding company controls a

private equity fund for purposes of this

subpart if the financial holding

company, including any director,

officer, employee or principal

shareholder of the financial holding

company:

(i) Serves as a general partner,

managing member, or trustee of the

private equity fund (or serves in a

similar role with respect to the private

equity fund);

(ii) Owns or controls 25 percent or

more of any class of voting shares or

similar interests in the private equity

fund;

(iii) In any manner selects, controls or

constitutes a majority of the directors,

trustees or management of the private

equity fund; or

(iv) Owns or controls more than 5

percent of any class of voting shares or

similar interests in the private equity

fund and is the investment adviser to

the fund.

8488 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

§ 225.174 What aggregate thresholds

apply to merchant banking investments?

(a) In general. A financial holding

company may not, without Board

approval, directly or indirectly acquire

any additional shares, assets or

ownership interests under this subpart

or make any additional capital

contribution to any company the shares,

assets or ownership interests of which

are held by the financial holding

company under this subpart if the

aggregate carrying value of all merchant

banking investments held by the

financial holding company under this

subpart exceeds:

(1) 30 percent of the Tier 1 capital of

the financial holding company; or

(2) After excluding interests in private

equity funds, 20 percent of the Tier 1

capital of the financial holding

company.

(b) How do these thresholds apply to

a private equity fund? Paragraph (a) of

this section applies to the interest

acquired or controlled by the financial

holding company under this subpart in

a private equity fund. Paragraph (a) of

this section does not apply to any

interest in a company held by a private

equity fund or to any interest held by a

person that is not affiliated with the

financial holding company.

(c) How long do these thresholds

remain in effect? This § 225.174 shall

cease to be effective on the date that a

final rule issued by the Board that

specifically addresses the appropriate

regulatory capital treatment of merchant

banking investments becomes effective.

§ 225.175 What risk management, record

keeping and reporting policies are required

to make merchant banking investments?

(a) What internal controls and records

are necessary?—(1) General. A financial

holding company, including a private

equity fund controlled by a financial

holding company, that makes

investments under this subpart must

establish and maintain policies,

procedures, records and systems

reasonably designed to conduct,

monitor and manage such investment

activities and the risks associated with

such investment activities in a safe and

sound manner, including policies,

procedures, records and systems

reasonably designed to:

(i) Monitor and assess the carrying

value, market value and performance of

each investment and the aggregate

portfolio;

(ii) Identify and manage the market,

credit, concentration and other risks

associated with such investments;

(iii) Identify, monitor and assess the

terms, amounts and risks arising from

transactions and relationships

(including contingent fees or contingent

interests) with each company in which

the financial holding company holds an

interest under this subpart;

(iv) Ensure the maintenance of

corporate separateness between the

financial holding company and each

company in which the financial holding

company holds an interest under this

subpart and protect the financial

holding company and its depository

institution subsidiaries from legal

liability for the operations conducted

and financial obligations of each such

company; and

(v) Ensure compliance with this part

and any other provisions of law

governing transactions and relationships

with companies in which the financial

holding company holds an interest

under this subpart (e.g., fiduciary

principles or sections 23A and 23B of

the Federal Reserve Act (12 U.S.C. 371c,

371c–1), if applicable).

(2) Availability of records. A financial

holding company must make the

policies, procedures and records

required by paragraph (a)(1) of this

section available to the Board or the

appropriate Reserve Bank upon request.

(b) What periodic reports must be

filed? A financial holding company

must provide reports to the appropriate

Reserve Bank in such format and at such

times as the Board may prescribe.

(c) Is notice required for the

acquisition of companies?—(1)

Fulfillment of statutory notice

requirement. Except as required in

paragraph (c)(2) of this section, no postacquisition notice under section 4(k)(6)

of the Bank Holding Company Act (12

U.S.C. 1843(k)(6)) is required by a

financial holding company in

connection with an investment made

under this subpart if the financial

holding company has previously filed a

notice under § 225.87 indicating that it

had commenced merchant banking

investment activities under this subpart.

(2) Notice of large individual

investments. A financial holding

company must provide written notice to

the Board on the appropriate form

within 30 days after acquiring more

than 5 percent of the voting shares,

assets or ownership interests of any

company under this subpart, including

an interest in a private equity fund, at

a total cost to the financial holding

company that exceeds the lesser of 5

percent of the Tier 1 capital of the

financial holding company or $200

million.

§ 225.176 How do the statutory cross

marketing and sections 23A and B

limitations apply to merchant banking

investments?

(a) Are cross marketing activities

prohibited?—(1) In general. A

depository institution, including a

subsidiary of a depository institution,

controlled by a financial holding

company may not:

(i) Offer or market, directly or through

any arrangement, any product or service

of any company if more than 5 percent

of the company’s voting shares, assets or

ownership interests are owned or

controlled by the financial holding

company pursuant to this subpart; or

(ii) Allow any product or service of

the depository institution, including any

product or service of a subsidiary of the

depository institution, to be offered or

marketed, directly or through any

arrangement, by or through any

company described in paragraph

(a)(1)(i) of this section.

(2) How are certain subsidiaries

treated? For purposes of paragraph (a)(1)

of this section, a subsidiary of a

depository institution does not include

a financial subsidiary held in

accordance with section 5136A of the

Revised Statutes (12 U.S.C. 24a) or

section 46 of the Federal Deposit

Insurance Act. (12 U.S.C. 1831w), any

company held by a company owned in

accordance with section 25 or 25A of

the Federal Reserve Act (12 U.S.C. 601

et seq.; 12 U.S.C. 611 et seq.), or any

company held by a small business

investment company owned in

accordance with the Small Business

Investment Act of 1958 (15 U.S.C. 661

et seq.).

(3) How do the cross marketing

restrictions apply to private equity

funds? The restriction contained in

paragraph (a)(1) of this section does not

apply to:

(i) Portfolio companies held by a

private equity fund that the financial

holding company does not control; or

(ii) The sale, offer or marketing of any

interest in a private equity fund,

whether or not controlled by the

financial holding company.

(b) When are companies held under

section 4(k)(4)(H) affiliates under

sections 23A and B?—(1) Rebuttable

presumption of control. The following

rebuttable presumption of control shall

apply for purposes of sections 23A and

23B of the Federal Reserve Act (12

U.S.C. 371c, 371c-1): if a financial

holding company directly or indirectly

owns or controls more than 15 percent

of the total equity of a company

pursuant to this subpart, the company

shall be presumed to be an affiliate of

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8489

any member bank that is affiliated with

the financial holding company.

(2) Request to rebut presumption. A

financial holding company may rebut

this presumption by providing

information acceptable to the Board

demonstrating that the financial holding

company does not control the company.

(3) Presumptions that control does not

exist. Absent evidence to the contrary,

the presumption in paragraph (b)(1) of

this section will be considered to have

been rebutted without Board approval

under paragraph (b)(2) of this section if

any one of the following requirements

are met:

(i) No officer, director or employee of

the financial holding company serves as

a director, trustee, or general partner (or

individual exercising similar functions)

of the company;

(ii) A person that is not affiliated or

associated with the financial holding

company owns or controls a greater

percentage of the equity capital of the

portfolio company than the amount

owned or controlled by the financial

holding company, and no more than one

officer or employee of the holding

company serves as a director or trustee

(or individual exercising similar

functions) of the company; or

(iii) A person that is not affiliated or

associated with the financial holding

company owns or controls more than 50

percent of the voting shares of the

portfolio company, and officers and

employees of the holding company do

not constitute a majority of the directors

or trustees (or individuals exercising

similar functions) of the company.

(4) Convertible instruments. For

purposes of paragraph (b)(1) of this

section, equity capital includes options,

warrants and any other instrument

convertible into equity capital.

(5) Application of presumption to

private equity funds. A financial

holding company will not be presumed

to own or control the equity capital of

a company for purposes of paragraph

(b)(1) of this section solely by virtue of

an investment made by the financial

holding company in a private equity

fund that owns or controls the equity

capital of the company unless the

financial holding company controls the

private equity fund as described in

§ 225.173(d)(4).

(6) Application of sections 23A and B

to U.S. branches and agencies of foreign

banks. Sections 23A and 23B of the

Federal Reserve Act (12 U.S.C. 371c,

371c–1) shall apply to all covered

transactions between each U.S. branch

and agency of a foreign bank that

acquires or controls, or that is affiliated

with a company that acquires or

controls, merchant banking investments

and—

(i) Any portfolio company that the

foreign bank or affiliated company

controls or is presumed to control under

paragraph (b)(1) of this section; and

(ii) Any company that the foreign

bank or affiliated company controls or is

presumed to control under paragraph

(b)(1) of this section if the company is

engaged in acquiring or controlling

merchant banking investments and the

proceeds of the covered transaction are

used for the purpose of funding the

company’s merchant banking

investment activities.

§ 225.177 Definitions.

(a) What do references to a financial

holding company include?—(1) Except

as otherwise expressly provided, the

term ‘‘financial holding company’’ as

used in this subpart means the financial

holding company and all of its

subsidiaries, including a private equity

fund or other fund controlled by the

financial holding company.

(2) Except as otherwise expressly

provided, the term ‘‘financial holding

company’’ does not include a depository

institution or subsidiary of a depository

institution or any portfolio company

controlled directly or indirectly by the

financial holding company.

(b) What do references to a depository

institution include? For purposes of this

subpart, the term ‘‘depository

institution’’ includes a U.S. branch or

agency of a foreign bank.

(c) What is a portfolio company? A

portfolio company is any company or

entity:

(1) That is engaged in any activity not

authorized for the financial holding

company under section 4 of the Bank

Holding Company Act (12 U.S.C. 1843);

and

(2) Any shares, assets or ownership

interests of which are held, owned or

controlled directly or indirectly by the

financial holding company pursuant to

this subpart, including through a private

equity fund that the financial holding

company controls.

(d) Who are the executive officers of

a company?—(1) An executive officer of

a company is any person who

participates or has the authority to

participate (other than in the capacity as

a director) in major policymaking

functions of the company, whether or

not the officer has an official title, the

title designates the officer as an

assistant, or the officer serves without

salary or other compensation.

(2) The term ‘‘executive officer’’ does

not include—

(i) Any person, including a person

with an official title, who may exercise

a certain measure of discretion in the

performance of his duties, including the

discretion to make decisions in the

ordinary course of the company’s

business, but who does not participate

in the determination of major policies of

the company and whose decisions are

limited by policy standards fixed by

senior management of the company; or

(ii) Any person who is excluded from

participating (other than in the capacity

of a director) in major policymaking

functions of the company by resolution

of the board of directors or by the

bylaws of the company and who does

not in fact participate in such

policymaking functions.

By order of the Board of Governors of the

Federal Reserve System, January 10, 2001.

Jennifer J. Johnson,

Secretary of the Board.

Department of the Treasury

12 CFR Chapter XV

Authority and Issuance

For the reasons set forth in the

preamble, the Department of the

Treasury revises part 1500 of subchapter

A of Chapter XV, Title 12 of the Code

of Federal Regulations to read as

follows:

PART 1500—MERCHANT BANKING

INVESTMENTS

Sec.

1500.1 What type of investments are

permitted by this part, and under what

conditions may they be made?

1500.2 What are the limitations on

managing or operating a portfolio

company held as a merchant banking

investment?

1500.3 What are the holding periods

permitted for merchant banking

investments?

1500.4 How are investments in private

equity funds treated under this part?

1500.5 What aggregate thresholds apply to

merchant banking investments?

1500.6 What risk management, record

keeping and reporting policies are

required to make merchant banking

investments?

1500.7 How do the statutory cross

marketing and sections 23A and B

limitations apply to merchant banking

investments?

1500.8 Definitions.

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

§ 1500.1 What type of investments are

permitted by this part, and under what

conditions may they be made?

(a) What types of investments are

permitted by this part? Section

4(k)(4)(H) of the Bank Holding Company

Act (12 U.S.C. 1843(k)(4)(H)) and this

part authorize a financial holding

company, directly or indirectly and as

8490 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

principal or on behalf of one or more

persons, to acquire or control any

amount of shares, assets or ownership

interests of a company or other entity

that is engaged in any activity not

otherwise authorized for the financial

holding company under section 4 of the

Bank Holding Company Act. For

purposes of this part, shares, assets or

ownership interests acquired or

controlled under section 4(k)(4)(H) and

this part are referred to as ‘‘merchant

banking investments.’’ A financial

holding company may not directly or

indirectly acquire or control any

merchant banking investment except in

compliance with the requirements of

this part.

(b) Must the investment be a bona fide

merchant banking investment? The

acquisition or control of shares, assets or

ownership interests under this part is

not permitted unless it is part of a bona

fide underwriting or merchant or

investment banking activity.

(c) What types of ownership interests

may be acquired? Shares, assets or

ownership interests of a company or

other entity include any debt or equity

security, warrant, option, partnership

interest, trust certificate or other

instrument representing an ownership

interest in the company or entity,

whether voting or nonvoting.

(d) Where in a financial holding

company may merchant banking

investments be made? A financial

holding company and any subsidiary

(other than a depository institution or

subsidiary of a depository institution)

may acquire or control merchant

banking investments. A financial

holding company and its subsidiaries

may not acquire or control merchant

banking investments on behalf of a

depository institution or subsidiary of a

depository institution.

(e) May assets other than shares be

held directly? A financial holding

company may not under this part

acquire or control assets, other than debt

or equity securities or other ownership

interests in a company, unless:

(1) The assets are held by or promptly

transferred to a portfolio company;

(2) The portfolio company maintains

policies, books and records, accounts,

and other indicia of corporate,

partnership or limited liability

organization and operation that are

separate from the financial holding

company and limit the legal liability of

the financial holding company for

obligations of the portfolio company;

and

(3) The portfolio company has

management that is separate from the

financial holding company to the extent

required by § 1500.2.

(f) What type of affiliate is required for

a financial holding company to make

merchant banking investments? A

financial holding company may not

acquire or control merchant banking

investments under this part unless the

financial holding company qualifies

under at least one of the following

paragraphs:

(1) Securities affiliate. The financial

holding company is or has an affiliate

that is registered under the Securities

Exchange Act of 1934 (15 U.S.C. 78c,

78o, 78o–4) as:

(i) A broker or dealer; or

(ii) A municipal securities dealer,

including a separately identifiable

department or division of a bank that is

registered as a municipal securities

dealer.

(2) Insurance affiliate with an

investment adviser affiliate. The

financial holding company controls:

(i) An insurance company that is

predominantly engaged in underwriting

life, accident and health, or property

and casualty insurance (other than

credit-related insurance), or providing

and issuing annuities; and

(ii) A company that:

(A) Is registered with the Securities

and Exchange Commission as an

investment adviser under the

Investment Advisers Act of 1940 (15

U.S.C. 80b–1 et seq.); and

(B) Provides investment advice to an

insurance company.

§ 1500.2 What are the limitations on

managing or operating a portfolio company

held as a merchant banking investment?

(a) May a financial holding company

routinely manage or operate a portfolio

company? Except as permitted in

paragraph (e) of this section, a financial

holding company may not routinely

manage or operate any portfolio

company.

(b) When does a financial holding

company routinely manage or operate a

company?

(1) Examples of routine management

or operation.—(i) Executive officer

interlocks at the portfolio company. A

financial holding company routinely

manages or operates a portfolio

company if any director, officer or

employee of the financial holding

company serves as or has the

responsibilities of an executive officer of

the portfolio company.

(ii) Interlocks by executive officers of

the financial holding company.—(A)

Prohibition. A financial holding

company routinely manages or operates

a portfolio company if any executive

officer of the financial holding company

serves as or has the responsibilities of

an officer or employee of the portfolio

company.

(B) Definition. For purposes of

paragraph (b)(1)(ii)(A) of this section,

the term ‘‘financial holding company’’

includes the financial holding company

and only the following subsidiaries of

the financial holding company:

(1) A securities broker or dealer

registered under the Securities

Exchange Act of 1934;

(2) A depository institution;

(3) An affiliate that engages in

merchant banking activities under this

part or insurance company investment

activities under section 4(k)(4)(I) of the

Bank Holding Company Act (12 U.S.C.

1843(k)(4)(I));

(4) A small business investment

company (as defined in section 302(b) of

the Small Business Investment Act of

1958 (15 U.S.C. 682(b)) controlled by

the financial holding company or by any

depository institution controlled by the

financial holding company; and

(5) Any other affiliate that engages in

significant equity investment activities

that are subject to a special capital

charge under the capital adequacy rules

or guidelines of the Board.

(iii) Covenants regarding ordinary

course of business. A financial holding

company routinely manages or operates

a portfolio company if any covenant or

other contractual arrangement exists

between the financial holding company

and the portfolio company that would

restrict the portfolio company’s ability

to make routine business decisions,

such as entering into transactions in the

ordinary course of business or hiring

officers or employees other than

executive officers.

(2) Presumptions of routine

management or operation. A financial

holding company is presumed to

routinely manage or operate a portfolio

company if:

(i) Any director, officer, or employee

of the financial holding company serves

as or has the responsibilities of an

officer (other than an executive officer)

or employee of the portfolio company;

or

(ii) Any officer or employee of the

portfolio company is supervised by any

director, officer, or employee of the

financial holding company (other than

in that individual’s capacity as a

director of the portfolio company).

(c) How may a financial holding

company rebut a presumption that it is

routinely managing or operating a

portfolio company? A financial holding

company may rebut a presumption that

it is routinely managing or operating a

portfolio company under paragraph

(b)(2) of this section by presenting

information to the Board demonstrating

to the Board’s satisfaction that the

financial holding company is not

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8491

routinely managing or operating the

portfolio company.

(d) What arrangements do not involve

routinely managing or operating a

portfolio company?—(1) Director

representation at portfolio companies. A

financial holding company may select

any or all of the directors of a portfolio

company or have one or more of its

directors, officers, or employees serve as

directors of a portfolio company if:

(i) The portfolio company employs

officers and employees responsible for

routinely managing and operating the

company; and

(ii) The financial holding company

does not routinely manage or operate

the portfolio company, except as

permitted in paragraph (e) of this

section.

(2) Covenants or other provisions

regarding extraordinary events. A

financial holding company may, by

virtue of covenants or other written

agreements with a portfolio company,

restrict the ability of the portfolio

company, or require the portfolio

company to consult with or obtain the

approval of the financial holding

company, to take actions outside of the

ordinary course of the business of the

portfolio company. Examples of the

types of actions that may be subject to

these types of covenants or agreements

include, but are not limited to, the

following:

(i) The acquisition of significant assets

or control of another company by the

portfolio company or any of its

subsidiaries;

(ii) Removal or selection of an

independent accountant or auditor or

investment banker by the portfolio

company;

(iii) Significant changes to the

business plan or accounting methods or

policies of the portfolio company;

(iv) Removal or replacement of any or

all of the executive officers of the

portfolio company;

(v) The redemption, authorization or

issuance of any equity or debt securities

(including options, warrants or

convertible shares) of the portfolio

company or any borrowing by the

portfolio company outside of the

ordinary course of business;

(vi) The amendment of the articles of

incorporation or by-laws (or similar

governing documents) of the portfolio

company; and

(vii) The sale, merger, consolidation,

spin-off, recapitalization, liquidation,

dissolution or sale of substantially all of

the assets of the portfolio company or

any of its significant subsidiaries.

(3) Providing advisory and

underwriting services to, and having

consultations with, a portfolio company.

A financial holding company may:

(i) Provide financial, investment and

management consulting advice to a

portfolio company in a manner

consistent with and subject to any

restrictions on such activities contained

in §§ 225.28(b)(6) or 225.86(b)(1) of the

Board’s Regulation Y (12 CFR

225.28(b)(6) and 225.86(b)(1));

(ii) Provide assistance to a portfolio

company in connection with the

underwriting or private placement of its

securities, including acting as the

underwriter or placement agent for such

securities; and

(iii) Meet with the officers or

employees of a portfolio company to

monitor or provide advice with respect

to the portfolio company’s performance

or activities.

(e) When may a financial holding

company routinely manage or operate a

portfolio company?—(1) Special

circumstances required. A financial

holding company may routinely manage

or operate a portfolio company only

when intervention by the financial

holding company is necessary or

required to obtain a reasonable return

on the financial holding company’s

investment in the portfolio company

upon resale or other disposition of the

investment, such as to avoid or address

a significant operating loss or in

connection with a loss of senior

management at the portfolio company.

(2) Duration Limited. A financial

holding company may routinely manage

or operate a portfolio company only for

the period of time as may be necessary

to address the cause of the financial

holding company’s involvement, to

obtain suitable alternative management

arrangements, to dispose of the

investment, or to otherwise obtain a

reasonable return upon the resale or

disposition of the investment.

(3) Notice required for extended

involvement. A financial holding

company may not routinely manage or

operate a portfolio company for a period

greater than nine months without prior

written notice to the Board.

(4) Documentation required. A

financial holding company must

maintain and make available to the

Board upon request a written record

describing its involvement in routinely

managing or operating a portfolio

company.

(f) May a depository institution or its

subsidiary routinely manage or operate

a portfolio company?—

(1) In general. A depository

institution and a subsidiary of a

depository institution may not routinely

manage or operate a portfolio company

in which an affiliated company owns or

controls an interest under this part.

(2) Definition applying provisions

governing routine management or

operation. For purposes of this section

other than paragraph (e) and for

purposes of § 1500.4(d), a financial

holding company includes a depository

institution controlled by the financial

holding company and a subsidiary of

such a depository institution.

(3) Exception for certain subsidiaries

of depository institutions. For purposes

of paragraph (e) of this section, a

financial holding company includes a

financial subsidiary held in accordance

with section 5136A of the Revised

Statutes (12 U.S.C. 24a) or section 46 of

the Federal Deposit Insurance Act (12

U.S.C. 1831w), and a subsidiary that is

a small business investment company

and that is held in accordance with the

Small Business Investment Act (15

U.S.C. 661 et seq.), and such a

subsidiary may, in accordance with the

limitations set forth in this section,

routinely manage or operate a portfolio

company in which an affiliated

company owns or controls an interest

under this part.

§ 1500.3 What are the holding periods

permitted for merchant banking

investments?

(a) Must investments be made for

resale? A financial holding company

may own or control shares, assets and

ownership interests pursuant to this

part only for a period of time to enable

the sale or disposition thereof on a

reasonable basis consistent with the

financial viability of the financial

holding company’s merchant banking

investment activities.

(b) What period of time is generally

permitted for holding merchant banking

investments?—(1) In general. Except as

provided in this section or § 1500.4, a

financial holding company may not,

directly or indirectly, own, control or

hold any share, asset or ownership

interest pursuant to this part for a

period that exceeds 10 years.

(2) Ownership interests acquired from

or transferred to companies held under

this part. For purposes of paragraph

(b)(1) of this section, shares, assets or

ownership interests—

(i) Acquired by a financial holding

company from a company in which the

financial holding company held an

interest under this part will be

considered to have been acquired by the

financial holding company on the date

that the share, asset or ownership

interest was acquired by the company;

and

(ii) Acquired by a company from a

financial holding company will be

8492 Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations

considered to have been acquired by the

company on the date that the share,

asset or ownership interest was acquired

by the financial holding company if—

(A) The financial holding company

held the share, asset, or ownership

interest under this part; and

(B) The financial holding company

holds an interest in the acquiring

company under this part.

(3) Interests previously held by a

financial holding company under

limited authority. For purposes of

paragraph (b)(1) of this section, any

shares, assets, or ownership interests

previously owned or controlled, directly

or indirectly, by a financial holding

company under any other provision of

the Federal banking laws that imposes

a limited holding period will if acquired

under this part be considered to have

been acquired by the financial holding

company under this part on the date the

financial holding company first

acquired ownership or control of the

shares, assets or ownership interests

under such other provision of law. For

purposes of this paragraph (b)(3), a

financial holding company includes a

depository institution controlled by the

financial holding company and any

subsidiary of such a depository

institution.

(4) Approval required to hold interests

held in excess of time limit. A financial

holding company may seek Board

approval to own, control or hold shares,

assets or ownership interests of a

company under this part for a period

that exceeds the period specified in

paragraph (b)(1) of this section. A

request for approval must:

(i) Be submitted to the Board at least

90 days prior to the expiration of the

applicable time period;

(ii) Provide the reasons for the

request, including information that

addresses the factors in paragraph (b)(5)

of this section; and

(iii) Explain the financial holding

company’s plan for divesting the shares,

assets or ownership interests.

(5) Factors governing Board

determinations. In reviewing any

proposal under paragraph (b)(4) of this

section, the Board may consider all the

facts and circumstances related to the

investment, including:

(i) The cost to the financial holding

company of disposing of the investment

within the applicable period;

(ii) The total exposure of the financial

holding company to the company and

the risks that disposing of the

investment may pose to the financial

holding company;

(iii) Market conditions;

(iv) The nature of the portfolio

company’s business;

(v) The extent and history of

involvement by the financial holding

company in the management and

operations of the company; and

(vi) The average holding period of the

financial holding company’s merchant

banking investments.

(6) Restrictions applicable to

investments held beyond time period. A

financial holding company that directly

or indirectly owns, controls or holds

any share, asset or ownership interest of

a company under this part for a total

period that exceeds the period specified

in paragraph (b)(1) of this section

must—

(i) For purposes of determining the

financial holding company’s regulatory

capital, apply to the financial holding

company’s adjusted carrying value of

such shares, assets, or ownership

interests a capital charge determined by

the Board that must be:

(A) Higher than the maximum

marginal Tier 1 capital charge

applicable under the Board’s capital

adequacy rules or guidelines (see 12

CFR 225 Appendix A) to merchant

banking investments held by that

financial holding company; and

(B) In no event less than 25 percent

of the adjusted carrying value of the

investment; and

(ii) Abide by any other restrictions

that the Board may impose in

connection with granting approval

under paragraph (b)(4) of this section.

§ 1500.4 How are investments in private

equity funds treated under this part?

(a) What is a private equity fund? For

purposes of this part, a ‘‘private equity

fund’’ is any company that:

(1) Is formed for the purpose of and

is engaged exclusively in the business of

investing in shares, assets, and

ownership interests of financial and

nonfinancial companies for resale or

other disposition;

(2) Is not an operating company;

(3) No more than 25 percent of the

total equity of which is held, owned or

controlled, directly or indirectly, by the

financial holding company and its

directors, officers, employees and

principal shareholders;

(4) Has a maximum term of not more

than 15 years; and

(5) Is not formed or operated for the

purpose of making investments

inconsistent with the authority granted

under section 4(k)(4)(H) of the Bank

Holding Company Act (12 U.S.C.

1843(k)(4)(H)) or evading the limitations

governing merchant banking

investments contained in this part.

(b) What form may a private equity

fund take? A private equity fund may be

a corporation, partnership, limited

liability company or other type of

company that issues ownership interests

in any form.

(c) What is the holding period

permitted for interests in private equity

funds?

(1) In general. A financial holding

company may own, control or hold any

interest in a private equity fund under

this part and any interest in a portfolio

company that is owned or controlled by

a private equity fund in which the

financial holding company owns or

controls any interest under this part for

the duration of the fund, up to a

maximum of 15 years.

(2) Request to hold interest for longer

period. A financial holding company

may seek Board approval to own,

control or hold an interest in or held

through a private equity fund for a

period longer than the duration of the

fund in accordance with § 1500.3(b) of

this part.

(3) Application of rules. The rules

described in § 1500.3(b)(2) and (3)

governing holding periods of interests

acquired, transferred or previously held

by a financial holding company apply to

interests in, held through, or acquired

from a private equity fund.

(d) How do the restrictions on routine

management and operation apply to

private equity funds and investments

held through a private equity fund?—(1)

Portfolio companies held through a

private equity fund. A financial holding

company may not routinely manage or

operate a portfolio company that is

owned or controlled by a private equity

fund in which the financial holding

company owns or controls any interest

under this part, except as permitted

under § 1500.2(e).

(2) Private equity funds controlled by

a financial holding company. A private

equity fund that is controlled by a

financial holding company may not

routinely manage or operate a portfolio

company, except as permitted under

§ 1500.2(e).

(3) Private equity funds that are not

controlled by a financial holding

company. A private equity fund may

routinely manage or operate a portfolio

company so long as no financial holding

company controls the private equity

fund or as permitted under § 1500.2(e).

(4) When does a financial holding

company control a private equity fund?

A financial holding company controls a

private equity fund for purposes of this

part if the financial holding company,

including any director, officer,

employee or principal shareholder of

the financial holding company:

(i) Serves as a general partner,

managing member, or trustee of the

private equity fund (or serves in a

Federal Register / Vol. 66, No. 21 / Wednesday, January 31, 2001 / Rules and Regulations 8493

similar role with respect to the private

equity fund);

(ii) Owns or controls 25 percent or

more of any class of voting shares or

similar interests in the private equity

fund;

(iii) In any manner selects, controls or

constitutes a majority of the directors,

trustees or management of the private

equity fund; or

(iv) Owns or controls more than 5

percent of any class of voting shares or

similar interests in the private equity

fund and is the investment adviser to

the fund.

§ 1500.5 What aggregate thresholds apply

to merchant banking investments?

(a) In general. A financial holding

company may not, without Board

approval, directly or indirectly acquire

any additional shares, assets or

ownership interests under this part or

make any additional capital

contribution to any company the shares,

assets or ownership interests of which

are held by the financial holding

company under this part if the aggregate

carrying value of all merchant banking

investments held by the financial

holding company under this part

exceeds:

(1) 30 percent of the Tier 1 capital of

the financial holding company; or

(2) After excluding interests in private

equity funds, 20 percent of the Tier 1

capital of the financial holding company

(b) How do these thresholds apply to

a private equity fund? Paragraph (a) of

this section applies to the interest

acquired or controlled by the financial

holding company under this part in a

private equity fund. Paragraph (a) of this

section does not apply to any interest in

a company held by a private equity fund

or to any interest held by a person that

is not affiliated with the financial

holding company.

(c) How long do these thresholds

remain in effect? This § 1500.5 shall

cease to be effective on the date that a

final rule issued by the Board that

specifically addresses the appropriate

regulatory capital treatment of merchant

banking investments becomes effective.

§ 1500.6 What risk management, record

keeping and reporting policies are required

to make merchant banking investments?

(a) What internal controls and records

are necessary?—(1) General. A financial

holding company, including a private

equity fund controlled by a financial

holding company, that makes

investments under this part must

establish and maintain policies,

procedures, records and systems

reasonably designed to conduct,

monitor and manage such investment

activities and the risks associated with

such investment activities in a safe and

sound manner, including policies,

procedures, records and systems

reasonably designed to:

(i) Monitor and assess the carrying

value, market value and performance of

each investment and the aggregate

portfolio;

(ii) Identify and manage the market,

credit, concentration and other risks

associated with such investments;

(iii) Identify, monitor and assess the

terms, amounts and risks arising from

transactions and relationships

(including contingent fees or contingent

interests) with each company in which

the financial holding company holds an

interest under this part;

(iv) Ensure the maintenance of

corporate separateness between the

financial holding company and each

company in which the financial holding

company holds an interest under this

part and protect the financial holding

company and its depository institution

subsidiaries from legal liability for the

operations conducted and financial

obligations of each such company; and

(v) Ensure compliance with this part.

(2) Availability of records. A financial

holding company must make the

policies, procedures and records

required by paragraph (a)(1) of this

section available to the Board or the

appropriate Reserve Bank upon request.

(b) Certain additional recordkeeping

and reporting requirements for

merchant banking investments are set

forth in the Board’s Regulation Y, 12

CFR 225.175.

§ 1500.7 How do the statutory cross

marketing and sections 23A and B

limitations apply to merchant banking

investments?

Certain cross-marketing limitations

and limitations under sections 23A and

23B of the Federal Reserve Act (12

U.S.C. 371c, 371c-1) applicable to

merchant banking investments are set

forth in the Board’s Regulation Y, 12

CFR 225.176.

§ 1500.8 Definitions.

(a) What do references to a financial

holding company include?—(1) Except

as otherwise expressly provided, the

term ‘‘financial holding company’’ as

used in this part means the financial

holding company and all of its

subsidiaries, including a private equity

fund or other fund controlled by the

financial holding company.

(2) Except as otherwise expressly

provided, the term ‘‘financial holding

company’’ does not include a depository

institution or subsidiary of a depository

institution or any portfolio company

controlled directly or indirectly by the

financial holding company.

(b) What do references to a depository

institution include? For purposes of this

part, the term ‘‘depository institution’’

includes a U.S. branch or agency of a

foreign bank.

(c) What is a portfolio company? A

portfolio company is any company or

entity:

(1) That is engaged in any activity not

authorized for the financial holding

company under section 4 of the Bank

Holding Company Act (12 U.S.C. 1843);

and

(2) Any shares, assets or ownership

interests of which are held, owned or

controlled directly or indirectly by the

financial holding company pursuant to

this part, including through a private

equity fund that the financial holding

company controls.

(d) Who are the executive officers of

a company?—(1) An executive officer of

a company is any person who

participates or has the authority to

participate (other than in the capacity as

a director) in major policymaking

functions of the company, whether or

not the officer has an official title, the

title designates the officer as an

assistant, or the officer serves without

salary or other compensation.

(2) The term ‘‘executive officer’’ does

not include—

(i) Any person, including a person

with an official title, who may exercise

a certain measure of discretion in the

performance of his duties, including the

discretion to make decisions in the

ordinary course of the company’s

business, but who does not participate

in the determination of major policies of

the company and whose decisions are

limited by policy standards fixed by

senior management of the company; or

(ii) Any person who is excluded from

participating (other than in the capacity

of a director) in major policymaking

functions of the company by resolution

of the board of directors or by the

bylaws of the company and who does

not in fact participate in such

policymaking functions.

(e) What is the Board? The Board

means the Board of Governors of the

Federal Reserve System.

(f) How are other terms that are used

in this part defined? Unless otherwise

defined in this part, all terms used have

the meanings given such terms in the

Board’s Regulation Y (12 CFR Part 225).

Dated: January 10, 2001.

Gregory A. Baer,

Assistant Secretary for Financial Institutions,

Department of the Treasury.

[FR Doc. 01–1305 Filed 1–30–01; 8:45 am]

BILLING CODES 6210–01–P; 4810–25–P