[Federal Register Volume 66, Number 21 (Wednesday, January 31, 2001)]
[Rules and Regulations]
[Pages 8466-8493]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-1305]



[[Page 8465]]

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Part II





Federal Reserve System





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12 CFR Part 225





Department of the Treasury





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Office of the Under Secretary for Domestic Finance



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12 CFR Part 1500



Bank Holding Companies and Change in Bank Control; Final Rule

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

[[Page 8466]]


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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.

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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 Gramm-Leach-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.
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    \1\ Pub. L. 106-102, 113 Stat. 1338 (1999).
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    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.
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    \2\ 65 FR 16460 (March 28, 2000).
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    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

[[Page 8467]]

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.
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    \3\ See 65 FR 16460, 16461-62 (March 28, 2000).
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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--
    <bullet> 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;
    <bullet> 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;
    <bullet> 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;
    <bullet> 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;
    <bullet> Streamlined the recordkeeping and reporting provisions of 
the rule to reduce burden;
    <bullet> Clarified the circumstances in which the cross-marketing 
provisions apply; and
    <bullet> 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\
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    \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).
    \5\ See, e.g., 12 U.S.C. 1844; 12 U.S.C. 1818(b)(3).

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[[Page 8468]]

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

[[Page 8469]]

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\
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    \8\ Nothing 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.
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    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\
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    \9\ See, e.g., 12 U.S.C. 1843(l)(2); 12 CFR 225.84.
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    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\
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    \10\ Although 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.
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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.
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    \11\ 12 U.S.C. Sec. 1843(k)(4)(H).
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    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\
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    \12\ Concentration 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).
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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

[[Page 8470]]

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.
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    \13\ A 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.
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    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 cross-marketing 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 Sec. 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

[[Page 8471]]

necessary protections for investors that did not involve the investor 
in the day-to-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-to-day 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.
---------------------------------------------------------------------------

    \14\ An ``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.
---------------------------------------------------------------------------

    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

[[Page 8472]]

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--
    <bullet> The acquisition of significant assets or control of 
another company by the portfolio company or any of its subsidiaries;
    <bullet> The removal or selection of the portfolio company's 
independent accountant or investment banker;
    <bullet> Significant changes to the portfolio company's business 
plan or accounting methods or policies;
    <bullet> The removal or replacement of any or all of the executive 
officers of the portfolio company;
    <bullet> The redemption, authorization or issuance of any equity or 
debt securities of the portfolio company;
    <bullet> Any borrowing by the portfolio company that is outside the 
ordinary course of business;
    <bullet> The amendment of the portfolio company's articles of 
incorporation or by-laws or similar governing documents; and
    <bullet> 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\
---------------------------------------------------------------------------

    \15\ See 12 CFR 225.28(b)(6) and 225.86(b)(1).
    \16\ See 12 CFR 225.28(b)(9) and 225.86(b)(1).
---------------------------------------------------------------------------

    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

[[Page 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.
---------------------------------------------------------------------------

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

    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 pre-existing 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

[[Page 8474]]

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.

[[Page 8475]]

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.
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    \18\ See, 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).
---------------------------------------------------------------------------

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 third-party 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 non-controlling 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 third-party 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, cross-
marketing 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

[[Page 8476]]

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.
---------------------------------------------------------------------------

    \19\ The 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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \20\ See 12 U.S.C. 1841(g)(1).
---------------------------------------------------------------------------

    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

[[Page 8477]]

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.
---------------------------------------------------------------------------

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

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 risk-management 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 dollar-based 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

[[Page 8478]]

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 decision-making 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.
---------------------------------------------------------------------------

    \22\ See 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.
---------------------------------------------------------------------------

    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--
    <bullet> Monitor and assess the carrying value, market value and 
performance of each merchant banking investment and the company's 
aggregate merchant banking investment portfolio;
    <bullet> Identify and manage the market, credit, concentration and 
other risks

[[Page 8479]]

associated with merchant banking investments;
    <bullet> 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;
    <bullet> 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
    <bullet> 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 on-site 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

[[Page 8480]]

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 post-transaction 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\
---------------------------------------------------------------------------

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

    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\
---------------------------------------------------------------------------

    \24\ See 65 FR 56,910 (Sept. 20, 2000); 65 FR 20,821 (April 18, 
2000).
    \25\ For 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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \26\ One 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).
---------------------------------------------------------------------------

    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 
so-called ``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,

[[Page 8481]]

whether or not the fund is controlled by a financial holding company.
---------------------------------------------------------------------------

    \27\ See H.R. Rep. 106-74, 106th Cong., 1st Sess. at 122-23 
(1999).
---------------------------------------------------------------------------

    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 cross-marketing 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\
---------------------------------------------------------------------------

    \28\ Likewise, 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.
---------------------------------------------------------------------------

    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 cross-marketing 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 case-by-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.
---------------------------------------------------------------------------

    \29\ The 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.
---------------------------------------------------------------------------

    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--
    <bullet> 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;
    <bullet> 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
    <bullet> 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\
---------------------------------------------------------------------------

    \30\ See 12 U.S.C. 371c(3)(A).
    \31\ See 12 U.S.C. 371c(b)(3)(A)(i).
---------------------------------------------------------------------------

    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

[[Page 8482]]

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.
---------------------------------------------------------------------------

    \32\ For 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.
---------------------------------------------------------------------------

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

[[Page 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 Gramm-Leach-
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

[[Page 8484]]

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:


Sec. 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


Sec. 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

[[Page 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 Sec. 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.


Sec. 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

[[Page 8486]]

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 Secs. 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 Sec. 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.


Sec. 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 Sec. 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

[[Page 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.


Sec. 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 Sec. 225.172(b) of this 
subpart.
    (3) Application of rules. The rules described in Sec. 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 Sec. 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 Sec. 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 Sec. 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.

[[Page 8488]]

Sec. 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 
Sec. 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.


Sec. 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 post-acquisition 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 Sec. 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.


Sec. 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

[[Page 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 Sec. 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.


Sec. 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).


Sec. 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

[[Page 8490]]

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 Sec. 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.


Sec. 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

[[Page 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 Secs. 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 Sec. 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.


Sec. 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 Sec. 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

[[Page 8492]]

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.


Sec. 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 Sec. 1500.3(b) of this part.
    (3) Application of rules. The rules described in Sec. 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 Sec. 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 Sec. 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 Sec. 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

[[Page 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.


Sec. 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 Sec. 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.


Sec. 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.


Sec. 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.


Sec. 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