[Federal Register Volume 65, Number 60 (Tuesday, March 28, 2000)]
[Rules and Regulations]
[Pages 16460-16479]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-7147]



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Part II





Federal Reserve System

Department of the Treasury





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12 CFR Parts 225 and 1500



Bank Holding Companies and Change in Bank Control; Interim Rule and 
Proposed Rule

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

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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 
Department of the Treasury.

ACTION: Interim rule, with request for public comments.

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SUMMARY: The Board of Governors of the Federal Reserve System and the 
Secretary of the Treasury jointly adopt on an interim basis, effective 
March 17, 2000, and solicit comment on a rule that will govern merchant 
banking investments made by financial holding companies. This rule 
implements provisions of the recently enacted Gramm-Leach-Bliley Act 
(GLB Act) that permit financial holding companies to make investments 
as part of a bona fide securities underwriting or merchant or 
investment banking activity. A summary of the rule appears below in the 
executive summary in the SUPPLEMENTARY INFORMATION section.

DATES: The interim rule is effective on March 17, 2000. Comments must 
be received on both the interim rule and the capital proposal by May 
22, 2000.

ADDRESSES: Comments should refer to docket number R-1065 and should be 
sent to Ms. Jennifer J. Johnson, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue, N.W., 
Washington, D.C. 20551 (or mailed electronically to 
[email protected]) and to Merchant Banking Regulation, 
Office of Financial Institution Policy, U.S. Department of the 
Treasury, 1500 Pennsylvania Avenue, N.W., Room SC 37, Washington, D.C. 
20220 (or mailed electronically to 
[email protected]). Comments addressed to Ms. Johnson 
also may be delivered to the Board's mail room between the hours of 
8:45 a.m. and 5:15 p.m. and, outside of those hours, to the Board's 
security control room. Both the mail room and the security control room 
are accessible from the Eccles Building courtyard entrance, located on 
20th Street between Constitution Avenue and C Street, N.W. Members of 
the public may inspect comments in Room MP-500 of the Martin Building 
between 9:00 a.m. and 5:00 p.m. on weekdays. Comments addressed to the 
Treasury Department may also be delivered to the Treasury Department 
mail room between the hours of 8:45 a.m. and 5:15 p.m. at the 15th 
Street entrance to the Treasury Building.

FOR FURTHER INFORMATION CONTACT:
    Board of Governors: Scott G. Alvarez, Associate General Counsel 
(202/452-3583), Kieran J. Fallon, Senior Counsel (202/452-5270), or 
Camille M. Caesar, Senior Attorney (202/452-3513), 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: Joan Affleck-Smith, Director, Office of 
Financial Institutions Policy (202/622-2740), Gerry Hughes, Senior 
Financial Economist (202/622-2740); Roberta K. McInerney, Assistant 
General Counsel (Banking and Finance) (202/622-0480) or Gary Sutton, 
Senior Banking Counsel (202/622-0480).

SUPPLEMENTARY INFORMATION:

A. Executive Summary

    This rule implements provisions of the recently enacted GLB Act 
that permit financial holding companies to make investments 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 include any amount up to all of the ownership interests in the 
company. The investments that may be made under this new authority are 
substantially broader in scope than the investment activities otherwise 
permissible for bank holding companies, and are referred to as 
``merchant banking investments.''
    The interim rule does not address or apply to securities 
underwriting, dealing or market making activities conducted under 
section 4(k)(4)(E) of the Bank Holding Company Act (BHC Act). Moreover, 
the authority granted by section 4(k)(4)(H) of the BHC Act to financial 
holding companies to make merchant banking investments is an 
alternative to any other authority that the financial holding company 
may have to make investments in nonfinancial companies under other 
provisions of the Bank Holding Company Act except as specifically noted 
in the rule.
    The interim rule sets forth the parameters within which financial 
holding companies may make merchant banking investments. As an initial 
matter, the GLB Act allows a financial holding company to make merchant 
banking investments if the financial holding company controls a 
securities affiliate or controls both an insurance underwriter and a 
registered investment adviser. The rule defines a securities affiliate 
for this purpose to be any registered securities broker or dealer.
    The GLB Act contains provisions that are designed to help maintain 
the separation between banking and commerce by limiting the time period 
that a merchant banking investment may be held by a financial holding 
company and the circumstances under which the financial holding company 
may routinely manage or operate a portfolio company. In particular, the 
GLB Act provides that merchant banking investments may be held only for 
a period of time that enables the sale or disposition of the investment 
on a reasonable basis consistent with the financial viability of 
merchant banking investment activities. The rule provides that, in most 
cases, merchant banking investments may be held for a 10-year period. 
The rule allows a financial holding company to invest in a qualifying 
private equity fund for the term of the fund, up to 15 years under 
certain circumstances.
    With respect to routinely managing or operating portfolio 
companies, the rule clarifies that director interlocks at the portfolio 
company and certain types of agreements and covenants that affect only 
extraordinary corporate events would not, as a general matter, be 
considered routine management or operation. The rule also provides that 
a financial holding company would be considered to be routinely 
managing or operating a portfolio company if the financial holding 
company establishes interlocks at the officer or employee level of the 
portfolio company or has certain other arrangements involving day-to-
day management or participation in ordinary business decisions. The 
rule sets forth those limited circumstances when it is permissible for 
a financial holding company to routinely manage or operate a portfolio 
company, requires

[[Page 16461]]

documentation of these interventions, and limits the duration of the 
involvement.
    The interim rule contains other provisions that are also designed 
to serve this fundamental purpose of maintaining the separation of 
banking and commerce as well as to promote the safe and sound conduct 
of merchant banking activities. In particular, the rule requires 
financial holding companies to establish policies and systems to 
monitor and assess the various risks associated with making merchant 
banking investments. The financial holding company must also establish 
policies for assuring the corporate separateness of companies held 
under the rule and limiting the potential that the financial holding 
company or its affiliated depository institutions may be legally liable 
for the financial obligations or operations of those companies. In 
addition, the rule implements the cross-marketing prohibitions of the 
GLB Act and the provisions of sections 23A and B of the Federal Reserve 
Act that restrict transactions between a depository institution and a 
portfolio company controlled by the same financial holding company.
    Recordkeeping and reporting requirements are also established in 
order to promote compliance with the provisions of the rule and the 
safe and sound conduct of the activity. These records include 
documentation of transactions and relationships between a financial 
holding company, including each of its subsidiaries, and a company held 
under the merchant banking authority, with special attention paid to 
transactions and relationships that are not on market terms.
    Also to limit the potential level of risk to a financial holding 
company and its affiliated depository institutions from merchant 
banking investments, the interim rule establishes aggregate investment 
limits. The new Subpart provides that a financial holding company may 
not make additional merchant banking investments if the aggregate 
carrying value of all merchant banking investments made by the 
financial holding company under the GLB Act exceeds (1) the lesser of 
30 percent of its Tier 1 capital or $6 billion, or (2) the lesser of 20 
percent of Tier 1 capital or $4 billion after excluding investments 
made by the financial holding company in private equity funds. A 
financial holding company may invest a greater amount with prior 
approval. As explained below, the Board and the Secretary believe these 
limits are necessary until appropriate capital rules are put in place 
and experience is gained in managing and supervising the risks of this 
activity.
    Chief among the elements necessary to address safety and soundness 
is the appropriate capital treatment for merchant banking investments 
made by financial holding companies. The Board and the Secretary have 
developed a proposal to address the appropriate capital charge for 
merchant banking investments. This proposal seeks comment on an 
amendment to the Board's capital guidelines for bank holding companies 
that, in general, would apply a 50 percent capital charge to all 
merchant banking investments made under the interim rule. The capital 
proposal also requests comment on whether similar capital treatment 
should be applied at the holding company level to investments by bank 
holding companies and their subsidiaries in nonfinancial companies 
through small business investment companies (whether held directly by 
the bank holding company or by a depository institution controlled by 
the bank holding company), under Regulation K, in less than 5% of the 
shares of companies under section 4(c)(6) or 4(c)(7) of the BHC Act, or 
by an insured state bank subsidiary in accordance with section 24 of 
the Federal Deposit Insurance Act (FDI Act).
    The interim rule is contained in a new Subpart J to the Board's 
Regulation Y and in a new Part 1500 of the rules of the Department of 
the Treasury. These new subparts are promulgated on an interim basis, 
effective on March 17, 2000, in order to provide guidance to financial 
holding companies regarding the definitions, limits and supervisory 
requirements that govern the activity of making merchant banking 
investments as soon as possible following the effective date of the 
relevant provisions of the GLB Act.
    The capital proposal is described below, and is published 
separately in accordance with the requirements of the Federal Register.
    The Board and the Secretary of the Treasury solicit comments on all 
aspects of the interim rule and will amend the rule as appropriate in 
response to comments received.

B. Background

Interviews With Securities Firms and Bank Holding Companies

    In order to gather information about how firms currently make 
merchant banking investments, staff of the Federal Reserve System and 
the Department of the Treasury conducted interviews with a number of 
securities firms that currently make merchant banking investments. 
System staff and Treasury staff also interviewed several bank holding 
companies that make more limited types of investments under existing 
authority. The attached rule reflects information collected in these 
interviews and the experience of the System in supervising the more 
limited types of investment activities permissible for bank holding 
companies.
    The interviews indicated that merchant banking investment 
activities conducted by major securities firms most often are conducted 
through private equity funds, which pool a financial institution's 
capital with funds from third-party investors. These investors are 
generally either institutions (such as other investment companies, 
pension funds, endowments, charitable organizations, investment units 
of financial institutions, and other companies) or individuals with 
high net worth. The securities firm is typically the sponsor and 
advisor to the fund as well as an investor in the fund. The private 
equity fund may be organized in corporate, partnership or other form, 
and by contract has a limited life that typically spans 10 years, with 
the possibility of limited extensions.
    Private equity funds typically have features, including 
compensation arrangements, that--in addition to the limited life of the 
fund--strongly encourage the resale of investments made by the fund. As 
a result of these incentives and structural arrangements, and given 
current economic conditions, investments made by private equity funds 
are typically sold within a period of between 3 and 5 years. In 
addition, private equity funds typically have policies, review 
committees or other measures that encourage funds to diversify holdings 
and/or limit the amount of the fund's capital invested in a single 
portfolio company.
    Securities firms also at times make merchant banking investments 
for the account of the securities firm and not through a private equity 
fund. These investments tended to be less significant than investments 
made through a private equity fund. The investment period for direct 
investments ranged from less than one year to somewhat longer than 10 
years, with investments most often held for an average of 5 years under 
current conditions.
    Securities firms and bank holding companies uniformly indicated 
that they apply higher internal capital charges against merchant 
banking investments than are applied to many other types of activities. 
The industry practice regarding the appropriate

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internal measures of capital required to support merchant banking 
activities reflects the greater risks associated with these 
investments, including the volatility and illiquidity of many 
investments, and the fact that portfolio companies are themselves often 
leveraged companies. Private equity funds supported their investment 
activities almost exclusively with capital contributed by investors. 
Occasionally, private equity funds rely on short-term leverage that is 
repaid with a capital call on investors. However, private equity funds 
do not appear to rely to any significant extent on debt to fund 
investment activities.
    Firms that make merchant banking investments impose internal 
capital charges that differ by firm and, in some cases, by type of 
investment. These capital charges range from 25 percent to 100 percent 
of the investment. Firms typically record investments initially at the 
lower of cost or market. Investments may be assigned an adjusted 
carrying value if a significant event occurs (such as an initial public 
offering, follow-up financing, or secondary capital raising events), 
subject to a discount that reflects the size of the firm's holding, the 
liquidity of the market for the shares held, the volatility of the 
market and other factors and that is applied prior to recognizing any 
unrealized gains on the investment. The securities firms all have 
policies for reviewing and recording the value of individual 
investments and the appropriate discounts to apply to the unrealized 
gains on investments.
    Securities firms use a variety of methods to monitor the condition 
of portfolio companies. The most important involve receiving formal and 
informal reports on both a periodic basis and in the case of 
significant events, and maintaining representation on the board of 
directors of the portfolio company. Securities firms typically 
participate to the fullest extent allowed under their ownership 
interest in selecting the board of directors of a portfolio company and 
often select officers and employees of the firm to serve on the board 
of the portfolio company. These directors exercise the full rights and 
responsibilities of a member of the board, but are not expected to 
become involved in the routine management or operation of a portfolio 
company, as a general matter.
    In both the private equity fund context and the direct investment 
context, securities firms indicated that the firm would on occasion 
become involved in routinely managing or operating a portfolio company. 
These interventions occur in limited situations when the merchant 
banker determines that intervention is necessary (1) to respond to an 
unusual event that directly affects the value of the investment, such 
as loss of portfolio company senior management, operational failures, 
major acquisitions, business plan changes and significant business 
losses, or (2) to facilitate the sale or disposition of the investment, 
such as participation in negotiations for sale of the portfolio company 
or the initial public offering of the company's shares. These 
interventions are temporary in most cases and usually take the form of 
increased consultation with the management of the portfolio company, 
exercise of review and veto rights over certain extraordinary decisions 
of management, replacement of management, and, in a small number of 
cases, temporary appointment of a representative of the investor as an 
officer of the portfolio company.

C. Interim Rule

    The GLB Act specifically provides that the Board and the Secretary 
of the Treasury may issue regulations implementing section 4(k)(4)(H) 
that they jointly determine to be appropriate to assure compliance with 
the purposes and prevent evasions of the BHC Act and the GLB Act and to 
protect depository institutions, including limiting transactions 
between depository institutions and companies controlled under section 
4(k)(4)(H) (12 U.S.C. 1843(k)(7)(A)) and reporting and recordkeeping 
requirements. The Board is also authorized by the BHC Act and other 
provisions of law to promulgate rules, including capital standards and 
reporting and recordkeeping requirements, consistent with the 
requirements and purposes of the BHC Act and other provisions.
    The proposed interim rule reflects the information collected in the 
interview process in defining the parameters of merchant banking 
activities, allowable holding periods, involvement in the management 
and operation of portfolio companies and the monitoring and risk 
management systems these firms have developed. As noted above, 
securities firms and others that make merchant banking investments 
recognized that merchant banking investments are often riskier, less 
liquid and more volatile than many other types of investments and often 
involve an investment in a leveraged company. Consequently, these 
investments require greater capital support, careful monitoring and 
valuation systems, specific policies for addressing diversification of 
investments, and carefully developed limits on the amount of funds put 
at risk in the activity. In each of these areas, the interim rule and 
proposal are consistent with industry practices in making, monitoring 
and managing the risks associated with merchant banking investments.
    At the same time, the Board and the Secretary recognize that, by 
its nature, an agency rule sets outside limits, and in several key 
areas--such as the duration of holding periods, internal capital 
charges, and level of involvement in management of portfolio 
companies--industry practice has been more conservative than--and well 
within--the outside parameters set by the rule and proposal. In setting 
outside limits, the Board and the Secretary do not intend to encourage 
behavior that is different than more conservative industry practice and 
expect to monitor merchant banking activities carefully and discourage 
migration from the norms for conducting these activities to the outer 
limits allowed under the rule and proposal.
    While the rule is being adopted on an interim basis, the Board and 
the Secretary welcome comments on all aspects of the interim rule. 
These comments will be carefully considered and adjustments made to the 
interim rule as appropriate before its final adoption.

Section 225.170--What Investments Are Permitted Under This Subpart and 
Who May Make Them?

    As noted above, section 4(k)(4)(H) and the interim rule permit a 
financial holding company to acquire or control shares, assets or 
ownership interests of any company that engages in activities that are 
not otherwise permissible for a financial holding company. Interests 
acquired or controlled under the interim rule are referred to as 
merchant banking investments, and a financial holding company must 
comply with the requirements of this interim rule in order to make such 
investments.
    A financial holding company is not required to obtain the Board's 
approval or provide notice to the Board before the financial holding 
company begins making merchant banking investments or acquires a 
company that makes merchant banking investments. A financial holding 
company must, however, file notice with the Board under section 4(k)(6) 
of the BHC Act and section 225.87 of Regulation Y (12 CFR 225.87) 
within 30 days after commencing merchant banking investment activities 
or acquiring any company that makes merchant banking investments.
    Section 4(k)(4)(H) provides that a financial holding company may 
acquire or control shares of a company under

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that section ``as part of a bona fide underwriting or merchant or 
investment banking activity.'' The Board and the Secretary wish to 
emphasize the importance of this requirement in preventing 
circumvention of one of the fundamental purposes of the GLB Act of 
maintaining the separation of banking and commerce.
    This requirement prevents the merchant banking authority from being 
used to engage in a nonfinancial activity. It distinguishes authorized 
merchant banking investments from strategic or other types of 
investments that are not permitted under the BHC Act or the GLB Act, 
such as the purchase of a commercial company or a real estate project 
made for the purposes of engaging in a commercial or other nonfinancial 
activity. Thus, for example, this authority could not be used by the 
financial holding company to engage in real estate development or other 
activities that have not been found to be financial.
    This ``bona fide'' requirement does not prevent the acquisition of 
an interest in a company engaged in real estate development as part of 
a diversified portfolio of investments by the financial holding company 
in connection with its merchant banking business and in accordance with 
the other restrictions in the interim rule. The Board and the Secretary 
recognize that investments in real estate are often part of a 
diversified merchant banking portfolio. The Board and the Secretary 
believe, however, that the subpart would not allow a financial holding 
company to acquire a real estate development company if that 
acquisition represented all or substantially all of the holding 
company's investments claimed under this subpart. The rule includes 
this ``bona fide'' provision, and the Board will carefully monitor 
merchant banking investments to ensure that they meet this requirement 
and that the merchant banking authorization is not used by a financial 
holding company to engage in impermissible nonfinancial activities.
    Under the statute and the rule, merchant banking investments 
include the full range of ownership interests, including securities, 
warrants, partnership interests, trust certificates, and other 
instruments representing an ownership interest in a company, whether 
the interest is voting or nonvoting. They also include any instrument 
convertible into a security or other ownership interest.
    Under the statute and the rule, merchant banking investments may 
represent any amount of ownership interests in a portfolio company, 
whether or not that amount results in control for purposes of the BHC 
Act. Thus, this authority allows a financial holding company the 
flexibility to use its merchant banking authority to acquire or control 
a nominal amount of shares of a portfolio company or all of the 
ownership interests in a portfolio company.
    The authority granted by section 4(k)(4)(H) is an alternative to 
the other authority granted to financial holding companies to make 
investments in nonfinancial companies under other provisions of the BHC 
Act.\1\ Moreover, the rule does not address or apply to securities 
underwriting, dealing or market-making activities conducted under 
section 4(k)(4)(E) of the BHC Act.
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    \1\ For purposes of determining whether an investment qualifies 
under the alternative authority for making investments granted by 
Regulation K and by sections 4(c)(6) and (7) of the BHC Act, a 
financial holding company must generally aggregate all investments 
held by the financial holding company in a single company.
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    The rule allows financial holding companies to make investments 
directly or through any subsidiary other than a depository institution 
or subsidiary of a depository institution.\2\ The rule also 
incorporates the provision of the GLB Act that prohibits a financial 
holding company from making merchant banking investments on behalf of a 
depository institution or subsidiary of a depository institution. For 
purposes of the provisions of the rule, the term ``financial holding 
company'' refers to the financial holding company and any direct or 
indirect subsidiary of the holding company other than a portfolio 
company. The term ``financial holding company'' does not include a 
depository institution controlled by the financial holding company or 
any subsidiary of such a depository institution, except for purposes of 
the routine management provisions of section 171 and the recordkeeping 
and reporting provisions of section 174.
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    \2\ A subsidiary of a member bank may make merchant banking 
investments only if, after five years, the Board and the Secretary 
jointly adopt rules in accordance with section 122 of the GLB Act 
that permit financial subsidiaries of member banks to make merchant 
banking investments.
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    Subsection (e) allows a financial holding company to acquire and 
hold ``assets'' (other than shares or other ownership interests) of a 
company. In keeping with the stricture in section 4(k)(4)(H) that 
assets be ``of a company,'' subsection (e) requires that assets 
acquired as a merchant banking investment, such as real estate or 
assets of a division of an operating company, be promptly placed in and 
held through a portfolio company that maintains strict corporate 
separation from the financial holding company in order to limit the 
liability of the financial holding company and its financial and 
depository institution affiliates for the financial obligations and 
operating risks of the asset.
    To take advantage of this new authority, section 4(k)(4)(H) of the 
BHC Act requires that a bank holding company become a financial holding 
company.\3\ In addition, the financial holding company must control 
either (1) a securities affiliate or (2) both an insurance underwriter 
and an investment adviser, registered under the Investment Advisers Act 
of 1940, that provides investment advice to an insurance company. 
Subsection (f) incorporates this requirement.
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    \3\ The Board recently adopted, on an interim basis, regulations 
governing the process by which a bank holding company may become a 
financial holding company. See 65 FR 3785 (January 25, 2000).
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    Subsection (f) also defines a ``securities affiliate'' to include 
any broker or dealer registered with the Securities and Exchange 
Commission. The adoption of this definition would allow a broader range 
of financial holding companies to make merchant banking investments 
than a definition restricted to securities underwriting firms.
    The Board and the Secretary request comment on whether this or 
another definition is appropriate. In particular, the Board and the 
Secretary request comment on whether ``securities affiliate'' should 
include a division of a bank that is registered as a municipal 
securities dealer. In this regard, the Board and Secretary seek comment 
on whether expertise or policies developed in the course of conducting 
specific types of securities activities may be necessary or appropriate 
for making merchant banking investments in a safe and sound manner.
    As noted above, the rule adopts the language of section 4(k)(4)(H) 
of the BHC Act that allows investments in any company ``engaged in any 
activity not authorized pursuant to [section 4 of the Bank Holding 
Company Act],'' that is, any company engaged in an activity that is not 
financial in nature or incidental to a financial activity or otherwise 
permissible for a financial holding company to conduct.\4\ This 
provision appears to have been included in recognition of the fact that 
other provisions of the BHC Act permit a financial holding company to 
make investments in companies that conduct

[[Page 16464]]

financial activities without resorting to merchant banking authority.
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    \4\ Nothing in the merchant banking provision 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.
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    This distinction, however, may have practical consequences for 
private equity funds. As a result of this distinction in the statute 
and other provisions of the GLB Act, a private equity fund controlled 
by a financial holding company would appear to be prohibited from 
acquiring any additional financial company if any insured depository 
institution controlled by the financial holding company fails to have 
at least a satisfactory CRA rating, or, potentially, does not remain 
well managed and well capitalized. The Board and the Secretary request 
comment on this and on what, if any, amendments to the rule would be 
appropriate to deal with such affiliations within the requirements of 
the GLB Act.

Section 225.171--What Are the Limitations on Managing or Operating a 
Portfolio Company Held as a Merchant Banking Investment?

    A financial holding company is prohibited by the GLB Act 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. Section 225.171 provides guidance on 
this statutory restriction.
    Under this section, a financial holding company is considered to be 
engaged in routinely managing or operating a portfolio company if any 
director, officer, employee or agent of the financial holding company 
serves as or has responsibilities of an officer or employee of the 
portfolio company. The Board and the Secretary seek comment on whether 
any such interlocks would be appropriate.
    Similarly, routinely managing or operating a company would include 
supervising any officer or employee of the portfolio company, other 
than through participation on the board of directors. The rule also 
defines routinely managing or operating a company to include any 
covenant or other contractual arrangement 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 
employees below the rank of the five most senior officers.
    In addition, the rule defines routinely managing or operating a 
company to include participation in the day-to-day operations of the 
portfolio company. It also includes participation in management 
decisions made in the ordinary course of business of the portfolio 
company (other than decisions in which directors of a company 
customarily participate in their capacity as a director).
    A financial holding company is not considered to be engaged in 
routinely managing or operating a portfolio company by virtue of having 
one or more representatives on the board of directors of the portfolio 
company. For this purpose, the Board's existing interpretations 
consider selection of a general partner to be the equivalent of 
selecting the board of directors. A representative of the financial 
holding company that serves as a director of a portfolio company may 
not routinely manage or operate the portfolio company, as discussed 
more fully above. In addition, in order for the financial holding 
company to have a director interlock without being considered to be 
routinely managing or operating a portfolio company, the portfolio 
company must employ officers and employees responsible for managing and 
operating the company, and no other arrangements or practices may exist 
that constitute routine management or operation of the portfolio 
company by the financial holding company.
    The rule anticipates that representatives of the financial holding 
company will participate fully in matters typically presented to 
directors to the same degree as any other director. This permits the 
current practice of merchant bankers of placing representatives on the 
board of directors of a portfolio company in order to monitor the 
success of the company and assist at the board of directors level in 
overseeing and providing strategic advice to the management of the 
portfolio company. At the same time, the rule is intended to define as 
routine management or operation situations in which a representative of 
the financial holding company takes on responsibilities or is involved 
in decisions that are typically made by officers or employees of a 
portfolio company and not customarily considered by directors.
    The section identifies a set of covenants and other written 
agreements between a financial holding company and a portfolio company, 
that, in the absence of circumstances that would indicate otherwise, 
are not considered to represent routinely managing or operating a 
portfolio company. These agreements and covenants may require the 
portfolio company to seek the approval of, or to consult with, the 
financial holding company before taking actions outside of the ordinary 
course of business, including (i) the acquisition of assets of another 
company; (ii) significant revision of the business plan; (iii) 
redemption, authorization or issuance of any shares of capital stock 
(including options, warrants or convertible shares) by the portfolio 
company; and (iv) the sale, merger, consolidation, spin-off, 
recapitalization, liquidation or dissolution of the portfolio company 
or any of its significant subsidiaries, or of all or substantially all 
of the assets of such company or subsidiary.
    Under the Act and the rule, a financial holding company may 
routinely manage or operate a portfolio company under limited 
circumstances. The rule provides that this type of intervention is 
permitted only when necessary to address a material risk to the value 
or operation of the portfolio company. This might include a significant 
operating loss or a loss of senior management. This involvement must be 
temporary, and last only for the time necessary for the financial 
holding company to address the cause of involvement, obtain suitable 
alternative management arrangements, dispose of the investment or 
otherwise obtain a reasonable return on the investment. The rule would 
require a financial holding company to obtain Board approval to 
routinely manage or operate a portfolio company for a period greater 
than six months, and requires that a financial holding company document 
each instance of its involvement in routinely managing or operating a 
portfolio company.
    The rule provides that a depository institution or subsidiary 
(other than a financial subsidiary held in accordance with section 
5136A of the Revised Statutes or section 46 of the Federal Deposit 
Insurance Act) of a depository institution may not under any 
circumstances manage or operate a company held under this rule. This 
limitation would also apply to U.S. branches and agencies of foreign 
banks. The rule would, however, allow a director, officer or employee 
of a depository institution (or subsidiary of a depository institution) 
or U.S. branch or agency to serve as a director of a portfolio company 
to the same extent as would be permitted for a representative of a 
financial holding company.
    As explained more fully below, the rule permits merchant banking 
investments to be made through so-called private equity funds that are 
subject to several limits different than those that apply to other 
merchant banking investments. The rule contemplates that a financial 
holding

[[Page 16465]]

company may control and manage a private equity fund or may be a 
passive investor in the fund. The restrictions on routinely managing or 
operating portfolio companies acquired or controlled by the private 
equity fund apply to both the financial holding company and the private 
equity fund.
    The Board and the Secretary request comment on each of these 
provisions. In particular, comment is requested on whether there are 
additional situations in which a financial holding company should be 
permitted routinely to manage or operate a portfolio company consistent 
with the statute and its purpose of preventing the mixing of banking 
and commerce. Comment is also sought on whether additional agreements 
and covenants should be included in the list of arrangements that would 
not represent routine management or operation of the portfolio company.

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 merchant banking activity. The rule incorporates this 
statutory limitation.
    Consistent with industry practice, the rule generally would allow 
merchant banking investments to be held for a period of up to 10 years. 
Interests held by a financial holding company in private equity funds 
(defined below) could be held for the life of the fund, up to 15 years 
under circumstances described below.
    The rule allows a greater period for holding merchant banking 
investments, including investments in or by private equity funds, in 
exceptional circumstances, with Board approval. To receive that 
approval, the financial holding company must explain the financial 
holding company's plan for divesting the investment. In determining 
whether to grant the extension, the Board may consider the cost to the 
financial holding company of disposing of the investment within the 
applicable time period. The Board may also consider 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. In addition, the Board may consider market 
conditions and any other relevant information, such as the financial 
holding company's history of timely disposition of investments. The 
rule provides that a request for additional time must be filed at least 
1 year prior to the expiration of the normal holding period.
    The rule also establishes several supervisory restrictions designed 
to discourage investments from being held beyond the applicable period 
described above (i.e., 10 years in general, and up to 15 years under 
certain circumstances for investments made in a private equity fund). 
First, the rule requires a financial holding company that has held, 
owned, or controlled a merchant banking investment for longer than the 
applicable period to deduct 100 percent of the carrying value of its 
investment from the holding company's Tier 1 capital and does not allow 
the financial holding company to include any of the unrealized gains on 
the investment in its Tier 2 capital for regulatory purposes. The 
financial holding company is also prohibited from entering into any 
additional contractual arrangements or other relationships with the 
company or extending any additional credit to the company without Board 
approval. These requirements would apply in addition to any 
restrictions that the Board might impose in granting approval for an 
extended holding period.
    As noted above, the rule establishes somewhat different holding 
periods for investments made in private equity funds. The rule defines 
a ``private equity fund'' based on prevalent industry practice. A 
qualifying private equity fund is defined as any company that is not an 
operating company and that engages exclusively in merchant banking 
activities. The fund may be organized in any form, including a 
partnership, corporation or limited liability company. The fund may, 
but need not be, registered as an investment company under the Federal 
securities laws.
    To meet the rule's definition, a private equity fund must be owned 
by at least 10 investors that are unrelated to the financial holding 
company (and are not officers, directors, employees or principal 
shareholders of the financial holding company) and the financial 
holding company (including its officers, directors, employees and 
principal shareholders) may not own or control more than 25 percent of 
the equity capital 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 (except to the extent the fee increases the equity capital owned 
or controlled by the financial holding company above the 25 percent 
threshold described above).
    To qualify, a fund must invest in shares, assets or ownership 
interests of companies for the purpose of reselling or disposing of 
them and must establish a plan for the resale or disposition of its 
investments. In addition, the fund must have a limited life that does 
not exceed 12 years, with the possibility of three 1-year extensions 
with the approval of persons holding a majority of the fund's equity. 
The rule does not, however, impose the 10-year holding period on 
portfolio companies held by private equity funds.
    A fund cannot ``routinely manage or operate'' the portfolio 
companies in which it invests except in the situations identified in 
section 225.171. A fund is also expected to have policies to address 
diversification of its portfolio, which may include single investment 
limits, review of large investments by investors other than the 
adviser, or other approaches. Finally, the fund must not be established 
or operated to evade the limitations on merchant banking activities 
contained in the GLB Act or the rule.
    A financial holding company may, without Board approval, own or 
control a private equity fund that meets these requirements for the 
term of the fund up to 12 years, plus three additional one-year 
increments that may be obtained with the approval of a majority of the 
investors in the fund. In addition, different aggregate limits, 
reporting requirements and recordkeeping requirements apply to private 
equity funds and interests held by a financial holding company in 
private equity funds.
    Moreover, as explained more fully below, the restrictions on cross-
marketing, the limitations of sections 23A and 23B of the Federal 
Reserve Act, and the reporting and recordkeeping requirements of the 
rule, do not apply to a financial holding company that holds a passive 
interest in a private equity fund that is controlled or sponsored and 
advised by an unrelated third party. These requirements, however, would 
apply to a financial holding company that controls the private equity 
fund.
    These differences recognize that private equity funds typically are 
established for the purpose of making investments for resale and have a 
limited term and a number of other incentives and terms that encourage 
the resale or disposition of investments within a reasonable period. 
Importantly, investments made by private equity funds also are 
monitored by outside

[[Page 16466]]

investors that encourage resale of investments.
    A financial holding company may also own an interest in or control 
an investment vehicle or fund that makes merchant banking investments 
but that does not meet the rule's definition of a private equity fund. 
If a financial holding company controls the investment vehicle or fund, 
then investments made by the investment vehicle or fund are subject to 
the 10-year holding period and the other provisions of the rule 
governing ownership or control of a portfolio company. If a financial 
holding company owns an interest in, without controlling, such an 
investment vehicle or fund, the interest is treated as an interest in a 
portfolio company for purposes of the rule.
    The rule also contains a provision that prevents a financial 
holding company from attempting to circumvent the holding periods by 
transferring merchant banking investments 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.
    The Board and the Secretary request comment on whether the approach 
taken in the rule is appropriate or whether more specific limits on 
investments should be adopted. The Board and the Secretary also request 
comment on whether additional incentives are necessary or appropriate 
to assure that merchant banking investments are held only for a 
reasonable period consistent with the financial viability of the 
activity.
    The Board and the Secretary also request comment on whether it is 
appropriate or useful to establish different rules for holding periods 
and other requirements for merchant banking investments made in and 
through private equity funds than those made by a financial holding 
company directly or otherwise. If it is appropriate and helpful, 
comment is invited on whether the proposed rule properly defines 
private equity funds and whether the limits contained in the rule are 
consistent with the requirements and purposes of the GLB Act and the 
BHC Act.

Section 225.173--What Aggregate Limits Apply to Merchant Banking 
Investments?

    The authority to make merchant banking investments is newly granted 
to those bank holding companies that have been certified as financial 
holding companies. As noted above, this authority is in addition to 
other authority provided to all bank holding companies (including 
financial holding companies) under the BHC Act to make investments. 
These existing authorities allow investments in nonfinancial companies 
to be made through small business investment companies, outside the 
United States under Regulation K, and in up to 5 percent of the voting 
shares of any company. In addition, a financial holding company may 
make investments under the GLB Act through insurance underwriting 
companies.
    The Board and the Secretary are concerned that rapid expansion of 
merchant banking activities, particularly given the flexibility 
provided for such investments under the GLB Act, may pose new and 
potentially significant risks to the safety and soundness of depository 
institutions affiliated with financial holding companies engaged in 
these activities. These risks seem particularly apparent and material 
if the financial holding company commits a significant portion of its 
capital to merchant banking investments without appropriate systems for 
monitoring and managing the risks of these activities, or if the 
financial holding company does not reserve sufficient capital to take 
account of the risks of these investments.
    Accordingly, until such time as the agencies and the industry have 
gained experience with supervising these activities and the rules 
governing the regulatory capital treatment of these investments are in 
place, the rule establishes two aggregate limits on merchant banking 
investments. The first threshold prevents a financial holding company 
from making additional merchant banking investments (including making 
additional capital contributions to a company held under the rule) if 
the aggregate carrying value to the financial holding company of all 
its merchant banking investments exceeds the lesser of 30 percent of 
the financial holding company's Tier 1 capital or $6 billion. A second 
sublimit applies to the aggregate carrying value of all merchant 
banking investments excluding investments made by the financial holding 
company in private equity funds. This sublimit is the lesser of 20 
percent of the financial holding company's Tier 1 capital or $4 
billion.
    The rule provides that a financial holding company may exceed 
either threshold with the prior approval of the Board. This gives the 
Board flexibility to deal with circumstances that may arise before 
final action in this area on the Board's capital proposal.
    In establishing these limits, the Board and the Secretary have 
considered that many securities firms that make merchant banking 
investments and many bank holding companies that conduct more limited 
investment activities already impose internal limits on the aggregate 
amount of capital that they will commit to these investments. The Board 
and the Secretary have also considered the current levels of investment 
activities of bank holding companies under existing authority. Neither 
threshold contained in the interim rule would apply to the existing 
activities of bank holding companies (or financial holding companies) 
conducted under other authority, such as authority to own a small 
business investment company, authority to make investments abroad under 
Regulation K, or authority to acquire 5 percent or less of the voting 
shares of any company.
    The Board and the Secretary request comment on whether these 
thresholds are appropriate, and, if the thresholds are retained, 
whether they should be increased or decreased, whether the mechanism 
for Board approval to exceed the thresholds should be retained, and 
whether the thresholds should be based on the initial cost of 
investments or the carrying value of investments. The Board and the 
Secretary also request comment on whether the limits on merchant 
banking investments should be structured to take account of the types 
and levels of other kinds of investments made by financial holding 
companies. In particular, should a higher limit be set for financial 
holding companies that do not have significant investments under other 
authorities.
    The Board and the Secretary expect to revisit these limits in 
connection with consideration of the final capital rules for this 
activity and as the agencies and the industry gain experience in 
conducting and supervising merchant banking activities and in 
implementing the proposed capital rules for investment activities.

Section 225.174--What Risk Management, Reporting and Record Keeping 
Policies Are Required To Make Merchant Banking Investments?

    This section requires financial holding companies to adopt 
policies, procedures and systems reasonably designed to manage the 
risks associated

[[Page 16467]]

with making merchant banking investments. It also requires policies and 
systems designed to monitor compliance with the statutory and 
regulatory provisions governing these activities. A financial holding 
company that controls a private equity fund or other company that makes 
investments under the interim rule is expected to establish the same 
types of systems and policies for monitoring and managing the risks of 
merchant banking investments acquired or controlled by the private 
equity fund or company as those required for other types of merchant 
banking investments.
    The list of policies, procedures and systems contained in the 
interim rule, as well as the recordkeeping requirements, are not 
intended to be exclusive. Instead, these lists are representative of 
the types of policies, procedures and systems that are important 
elements of a sound approach to monitoring merchant banking investment 
activities, and others will be needed to address the particular 
approach that each financial holding company takes to making merchant 
banking investments. Beyond the procedures and systems required by the 
rule, it is essential to prudently and profitably making merchant 
banking investments that a financial holding company retain qualified 
personnel and carefully manage and oversee investment decisions.
    Each financial holding company is expected to institute appropriate 
policies and systems to monitor and manage investment activities before 
the company commences the activity. The Board expects to conduct a 
review of the policies and systems, in particular the investment and 
risk management systems, of each financial holding company that makes 
merchant banking investments within a short period after the holding 
company commences the activity.
    Among the policies and systems that a financial holding company is 
expected to establish are policies and systems designed to identify and 
assess adequately the value of individual investments and of the 
aggregate portfolio. These systems must also adequately assess the 
total exposure of the financial holding company to each company 
acquired under the rule, and the diversification of the portfolio. A 
financial holding company must be able to identify and manage the 
market, liquidity, credit and other risks associated with merchant 
banking investments and the terms, amounts and types of transactions 
between the financial holding company (and each of its subsidiaries) 
and each company acquired under the rule.
    In addition, the policies and systems must be adequate to maintain 
corporate separateness between the financial holding company and each 
portfolio company and sufficient to protect the financial holding 
company from legal liability for the conduct of operations and for the 
financial obligations of portfolio companies. The financial holding 
company must also develop policies and a business structure to limit 
the legal liability of the financial holding company for the financial 
obligations and operating risks that may flow through a private equity 
fund controlled by the financial holding company. This may include 
establishing a corporation or limited liability company that would be 
the general partner of a private equity fund controlled by the 
financial holding company.
    Moreover, these systems and policies must be adequate for ensuring 
compliance with the statutory and regulatory provisions governing 
merchant banking activities, including the limits on holding period, 
routinely managing or operating a portfolio company, and the cross-
marketing and inter-company transaction limits imposed under other 
provisions of the GLB Act or other law.
    Subsection (b) requires generally that a financial holding company 
maintain at a central location certain types of records and supporting 
information. This section contemplates that financial holding companies 
will be able to satisfy these record keeping requirements by using 
reports and records that are prepared in the ordinary course of making 
a merchant banking investment or controlling a private equity fund and 
used to inform third-party investors of the type and status of merchant 
banking investments.
    In particular, these records and materials must document the 
company's policies for making merchant banking investments and for 
managing and monitoring the various risks and exposures created by 
these activities. These records would include, for example, 
documentation of the review process for making investments and for 
properly assessing the value of each investment. In addition, these 
records must detail the investment amount, carrying value, market 
value, performance data and financial statements for each merchant 
banking investment.
    These records must also include records of transactions between the 
financial holding company and companies held under the rule. In 
particular, these records must document transactions that are not on 
market terms.
    The financial holding company would be expected to make available 
any reports, including valuations of investments, given to co-investors 
by the financial holding company or given to other investors in a 
private equity fund. The financial holding company is also expected to 
document incentive arrangements (sometimes called overrides or carried 
interests) in connection with advising or controlling a fund under this 
rule, including the carrying value and market value of the arrangement 
and amounts distributed under the arrangement that may be contingent on 
future asset performance.
    Subsection (c) establishes annual and quarterly reporting 
requirements regarding merchant banking investments. The annual report 
focuses on investments that have been held for a period longer than 
five years. A private equity fund controlled by a financial holding 
company is only required to provide annual reports regarding 
investments that have been held by the fund for a period longer than 
eight years. A financial holding company that has made a passive non-
controlling investment in a private equity fund is only required to 
report its investment in the fund as part of an annual report after 
eight years and is not required to report investments held by the fund.
    The annual report must list and describe each investment held for 
the applicable period (i.e., longer than eight years in the case of 
private equity funds and longer than five years in all other cases) as 
of the date of the report. In addition, the report must briefly 
describe the historical cost of the investment, the market valuation of 
the investment as of the reporting date, and the schedule for 
divestiture of the investment. A financial holding company that does 
not sell or dispose of an investment within eight years (including in 
the case of private equity funds) must include in its annual report a 
detailed divestiture plan for the investment.
    The annual report must also include aggregate data regarding the 
merchant banking investments made by the financial holding company 
broadly divided by category. These categories would be divided by 
general industrial sector, geography (national, international or 
regional as appropriate), and holding periods.
    The quarterly report focuses entirely on aggregate data regarding 
the financial holding company's merchant banking portfolio. The report 
would require quarterly reporting of the total number

[[Page 16468]]

of investments made under the merchant banking authority, the aggregate 
cost of these investments, and the current valuation of the merchant 
banking portfolio (including any value assigned to any incentive 
arrangements related to a private equity fund). These aggregates would 
be reported for several categories of investment, such as investments 
made in private equity funds, investments made in publicly traded 
securities, and investments made in ownership interests that are not 
publicly traded.
    The Board expects shortly to issue forms that may be used to comply 
with the annual and quarterly reporting requirements.
    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 company under any authority granted in section 4(k). Merchant 
banking investments, by their nature, must be temporary and held for 
resale. Consequently, the Board believes that the filing of notice in 
connection with the acquisition of a company done in the course of 
conducting merchant banking activities is generally not needed, except 
in the context of large investments. Notice of substantial investments 
made under the merchant banking authority would allow the Board to 
monitor financial holding companies that have large exposures to single 
portfolio companies.
    On this basis, the rule provides that a financial holding company 
will fulfill the notice requirements of section 4(k)(6) of the BHC Act 
in connection with its merchant banking activities if the company files 
a notice with the Board within 30 days of making an acquisition of a 
company under the rule only in the situation where both: (1) The 
acquisition represents in excess of 5 percent of the voting shares, 
assets or ownership interests of the company and (2) the cost of the 
investment exceeds the lesser of 5 percent of the Tier 1 capital of the 
financial holding company or $200 million. This notice must briefly 
indicate the cost and funding of the investment, the percentage of 
regulatory capital that the investment represents, the nature of the 
company acquired and the type of investment, and the risk management 
measures that apply to this investment. A financial holding company 
qualifies for this streamlined notice procedure only if the financial 
holding company has notified the Board under section 225.87 of 
Regulation Y that the financial holding company has commenced or 
acquired a company engaged in making merchant banking investments.
    Comment is invited on each of the recordkeeping and reporting 
requirements. In particular, comment is sought on whether the requested 
information would be readily available and valuable if provided in 
either a quarterly or annual report, and on the burdens associated with 
the proposed reporting requirements. Comment is also requested on 
whether it is appropriate to provide different reporting requirements 
for investments made by and in private equity funds than other types of 
merchant banking investments.

Section 225.175--How do the Statutory Cross-Marketing and Section 23A 
and B Limitations Apply to Merchant Banking Investments?

    The GLB Act prohibits depository institutions controlled by the 
financial holding company from marketing or offering, directly or 
through any arrangement, any product or service of a company held under 
the rule 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 section 4(k)(4)(H). 
Section 225.175 of the interim rule implements this prohibition. In 
addition, this section includes the statutory presumption regarding 
control by a financial holding company of a company held under section 
4(k)(4)(H) for the purposes of sections 23A and 23B of the Federal 
Reserve Act.
    Subsection (a) addresses the prohibition on cross-marketing. The 
cross-marketing restrictions would apply to cross-marketing between a 
depository institution controlled by a financial holding company and 
any portfolio company, private equity fund or other investment vehicle 
in which the financial holding company has an interest under this 
subpart. The restrictions would not apply to cross-marketing with a 
portfolio company that is owned by a private equity fund or other 
investment vehicle, however, unless the financial holding company 
controls the private equity fund or investment vehicle. Where control 
exists, the financial holding company is deemed by the BHC Act to 
indirectly own the shares of the portfolio company held by the private 
equity fund or investment vehicle.
    The restrictions on cross-marketing are applied to the U.S. 
branches and agencies of foreign banks that conduct merchant banking 
activities in the United States or through a U.S. company. The cross-
marketing restrictions also apply to any subsidiary of a depository 
institution, other than a financial subsidiary held in accordance with 
section 5136A of the Revised Statutes or section 46 of the Federal 
Deposit Insurance Act.\5\ These so-called operating subsidiaries are 
considered to be and are authorized as a part of the depository 
institution.
---------------------------------------------------------------------------

    \5\ A financial subsidiary may engage in many of the activities 
permissible for a financial holding company, but may not engage in 
merchant banking activities, certain insurance underwriting 
activities, or real estate investment or development activities.
---------------------------------------------------------------------------

    Neither the GLB Act nor the rule applies these restrictions to 
cross-marketing by nondepository affiliates of the financial holding 
company. Moreover, the rule does not apply these restrictions to 
companies in which the financial holding company, either directly or 
through a private equity fund or other investment vehicle, owns less 
than 5 percent of the voting shares.
    The rule does not define cross-marketing activities. Cross-
marketing would not appear to cover efforts by a depository institution 
to syndicate a loan made to a portfolio company, the purchase by a 
depository institution for its own use of products or services of a 
portfolio company, or the provision of services or extensions of credit 
by the depository institution directly to the portfolio company. These 
latter two types of transactions would, of course, be governed by the 
requirements of sections 23A and 23B if the portfolio company is an 
affiliate of the depository institution.
    The Board and the Secretary request comment on whether it would be 
useful to include a definition of cross-marketing activities in the 
rule, and if so, invite comment on an appropriate definition. The Board 
and the Secretary also seek comment on the scope of the cross-marketing 
restrictions. In particular, comment is invited on whether these 
restrictions should be applied more broadly than in the interim rule or 
whether the statute permits a more limited application.
    Subsection (b) establishes a rebuttable presumption of control for 
purposes of the restrictions contained in section 23A and 23B of the 
Federal Reserve Act on transactions between an insured depository 
institution and its affiliates. Under sections 23A and 23B, certain 
types of transactions between an insured depository institution and an 
affiliate are subject to specific quantitative, qualitative and 
collateral requirements.
    Under the presumption contained in the GLB Act, a financial holding 
company or other person that, directly or indirectly, or acting through 
one or more other persons, owns or controls 15 percent or more of the 
equity capital of

[[Page 16469]]

any company held under this subpart is presumed to control that 
company. Equity capital includes voting and nonvoting shares, warrants, 
options and other instruments convertible into equity capital. The 
presumption may be rebutted with the agreement of the Board and the 
rule allows a financial holding company to submit any relevant 
information in an effort to rebut this presumption.
    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 that is engaged in making merchant banking investments. For 
purposes of determining whether a foreign bank or affiliate controls a 
company, the rule applies the rebuttable presumption applicable to 
domestic financial holding companies. These provisions promote 
competitive equity and safe and sound banking. The rule is intended to 
restrict lending by a foreign bank's branches and agencies to portfolio 
companies and to affiliated companies that are actually engaged in 
making merchant banking investments. It is not intended to restrict 
otherwise permissible lending to parent companies or other affiliated 
companies, unless the proceeds of such lending would be used by these 
companies to make, or fund the making of, merchant banking investments 
under this subpart.
    The rule recognizes that a financial holding company may make a 
passive investment in a private equity fund. In this case, the rule 
clarifies that a company controlled by a private equity fund will not 
be presumed to be an affiliate of a depository institution controlled 
by a financial holding company that has made an investment in the 
private equity fund unless the financial holding company controls the 
fund or has sponsored and advises the fund.
    Comment is invited on each of these provisions. In particular, 
comment is requested on whether there are specific situations that 
should be included in the rule in which the presumption under section 
23A and 23B should, by rule, be considered to be rebutted. Comment is 
also requested on the provisions applying sections 23A and 23B to 
certain transactions involving U.S. branches and agencies of foreign 
banks.

D. Capital Adequacy Proposal

    As discussed above, many firms that make merchant banking 
investments and engage in other types of investment activities 
internally allocate capital to these investments that is higher than 
they allocate to most banking assets in light of the greater risk, 
illiquidity and volatility of merchant banking and similar investments 
and the higher leverage that often is associated with portfolio 
companies. The internal capital allocation for these investments is 
generally many multiples of the current regulatory capital charge.
    After consideration of the industry practice and in consultation 
with the Secretary, the Board is proposing to modify the methods of 
calculating the risk-weighted and leverage capital ratios for bank 
holding companies to better address the risks associated with merchant 
banking and other investment activities. This capital proposal, which 
is described below and published separately, is based on information 
about firm accounting and capital policies that System and Treasury 
Department staff gathered in interviews with securities firms and bank 
holding companies that currently conduct merchant banking and other 
investment activities. The Board and the Secretary also note that the 
proposed capital treatment is similar to the approach to capital 
sufficiency that the Federal Deposit Insurance Corporation has adopted 
under section 24 of the FDI Act for investment in subsidiaries that 
engage in principal activities that are not permissible for a national 
bank.
    The Board and the Secretary view this capital proposal as a 
precaution that is necessary to prevent the buildup within banking 
organizations of excessive risk from merchant banking and other 
investment activities. In developing this proposal, they have 
considered the effect of the proposal on the existing activities of 
bank holding companies.
    As an initial matter, adoption of the capital proposal would not 
prevent any bank holding company from becoming a financial holding 
company or from taking advantage of the new powers granted under the 
GLB Act. The capital charge would be applied only at the holding 
company level on the consolidated organization. Consequently, the 
capital proposal would not affect the capital levels of any depository 
institution--which, under the GLB Act, determine whether a company 
qualifies to be a financial holding company--controlled by a bank 
holding company.
    In addition, the Board and the Secretary have reviewed a sampling 
of call reports of bank holding companies engaged currently in 
significant investment activities, including companies that are likely 
to seek to become financial holding companies. This review indicates 
that, with virtually no exception, bank holding companies would remain 
well capitalized on a consolidated basis even after applying the 
proposed capital charge on all of the investments currently made by 
these companies. Moreover, nearly all of these companies would be able 
to increase significantly their level of investment activity and 
continue to be well capitalized on a consolidated basis after applying 
the proposed capital charge.
    For these reasons, the capital proposal is not expected to have an 
effect on the level of investment activities conducted by bank holding 
companies. The capital proposal would, however, help to limit the 
potential harm to bank holding companies and depository institutions 
controlled by bank holding companies from the risks associated with 
investment activities.
    The proposal is being published for comment and, unlike the rule 
discussed above, is not being made effective on an interim basis. 
During the comment period, the Board and the Secretary will discuss the 
issues raised by this proposal with the other Federal banking agencies 
and with other appropriate functional regulators.
    Under the proposal, a financial holding company would be required 
to deduct from its regulatory Tier 1 capital an amount equal to 50 
percent of the total carrying value, as reflected on consolidated 
financial statements of the financial holding company, of all merchant 
banking investments. The financial holding company would deduct 100 
percent of the carrying value of such investments from the assets of 
the financial holding company for capital purposes.\6\
---------------------------------------------------------------------------

    \6\ Some investments are booked using ``available for sale'' 
(AFS) accounting. Under this accounting treatment, unrealized gains 
are not recognized in net income, and flow to a special segregated 
equity account that is not recognized as Tier 1 capital by the 
regulatory agencies. Under the current bank holding company capital 
rules, 45 percent of the gain on AFS equity securities may be 
included in Tier 2 capital. The proposal would continue this 
treatment but further require deduction from Tier 1 capital of 50 
percent of the reported cost (or fair value if lower for equity 
securities) of investments recorded as AFS. The reported cost or 
fair value of these investments would be deducted from risk-weighted 
and average consolidated assets.
---------------------------------------------------------------------------

    This capital charge would apply to all equity instruments and all 
debt instruments that are convertible into equity held under the 
merchant banking authority. It also would apply to all debt extended by 
a financial holding company to a portfolio company in which the 
financial holding company owns 15 percent or more of the total equity. 
The proposal contains exceptions for short-term secured loans

[[Page 16470]]

for working capital purposes, for loans in which at least half has been 
participated to third parties, and for loans that are guaranteed by the 
United States government. An exception is also proposed for extensions 
of credit by a depository institution controlled by the bank holding 
company that are fully collateralized in accordance with section 23A of 
the Federal Reserve Act and meet the other requirements of that 
section.
    The proposal would apply the same capital treatment to investments 
in nonfinancial companies held under Regulation K, in less than 5% of 
the shares of any company under sections 4(c)(6) or (7) of the BHC Act, 
held through an SBIC that is controlled by the bank holding company or 
a subsidiary depository institution, or held by a state bank subsidiary 
in accordance with section 24 of the FDI Act. This capital treatment 
would not apply to investments that are held in a trading account in 
accordance with applicable accounting principles and that are part of 
an underwriting, market making or dealing activity. Comment is 
requested on whether this exclusion is appropriate. In addition, 
comment is invited on whether passive investments in less than 5 
percent of the shares of publicly traded companies, where there is a 
ready market, should also be excluded or subjected to a lesser capital 
charge.
    The proposal applies the capital treatment to nonfinancial 
investment activities conducted by bank holding companies and their 
subsidiaries as well as to merchant banking investments for several 
reasons. Importantly, the risks associated with these investment 
activities do not vary according to the authority used to conduct the 
activity. Thus, similar investment activities should be given the same 
capital treatment regardless of the source of legal authority to make 
the investment. In addition, current regulatory capital treatment, 
which applies an 8 percent minimum capital charge to investments, was 
developed at a time when the investment activities of banking 
organizations were relatively small. In recent years, some bank holding 
companies have greatly expanded the level of their investment 
activities. The Board's capital proposal reflects the judgment that it 
is appropriate at this time, when the investment authority of banking 
organizations has also been greatly expanded, to revisit and revise 
regulatory capital treatment for all investment activities.
    The capital charge would not be applied to investments made by 
insurance company subsidiaries of financial holding companies held in 
accordance with section 4(k)(4)(I) of the BHC Act. The Board expects 
soon to seek comments on a proposal to de-consolidate functionally 
regulated insurance underwriting companies from the financial holding 
company for purposes of applying the Board's consolidated capital 
rules. The proposal would take account of the different accounting 
standards, business practices, and capital and supervisory regimes that 
apply to insurance underwriting companies.
    The Board and the Secretary recognize that the new authority 
accorded financial holding companies under the GLB Act may raise the 
possibility for arbitrage between an insurance company and its 
financial holding company affiliates designed to avoid the capital 
charges proposed for merchant banking and other investments. The Board 
and the Secretary seek comment on whether provisions should be included 
in the final capital rule that would apply to investments made through 
an insurance company the same capital charge at the holding company 
level as would be applied to merchant banking and other investments if 
the Board finds that such arbitrage is occurring within a particular 
holding company. The Board and the Secretary also invite comment on 
whether there are other mechanisms that would prevent such arbitrage.
    During the period prior to adoption of a final capital rule, 
financial holding companies that engage in merchant banking activities 
will be expected to adopt and implement internal capital and accounting 
policies that reflect the liquidity, market and other risks associated 
with the company's investment activities. An initial criterion for 
these internal capital and accounting policies is that they be capable 
of enabling the financial holding company to meet the terms of the 
proposed capital rule on its effective date, with minimal adjustment, 
and remain in compliance with applicable regulatory capital standards.
    The separate capital proposal requests comment on all aspects of 
the proposed capital charge, including the appropriateness of a 
separate capital charge for investment activities and the amount of the 
charge. For convenience, a detailed description of the proposed 
amendments to the Board's capital appendices follows.
    Section II. B of Appendix A to Part 225 would be amended by adding 
a new clause (v) at the end of the introductory paragraph stating that 
portfolio investments must be deducted from the sum of core Tier 1 
capital elements in the manner provided by the proposal. Section II. B 
would also be amended by adding a new section II.B.5 governing 
portfolio investments. This new provision would provide that fifty 
percent (50%) of the value of all portfolio investments made by the 
parent bank holding company or by its direct or indirect subsidiaries 
must be deducted from the consolidated parent banking organization's 
core Tier 1 capital components.
    The proposal defines a portfolio investment as any merchant banking 
investment made directly or indirectly by a financial holding company 
under section 4(k)(4)(H) of the BHC Act, and any investment made 
directly or indirectly in a nonfinancial company by any bank holding 
company pursuant to section 4(c)(6), or 4(c)(7) of the BHC Act, section 
211.5(b)(1)(iii) of the Board's Regulation K, section 302(b) of the 
Small Business Investment Act of 1958, or by an insured state bank 
subsidiary in accordance with section 24 of the FDI Act.
    For this purpose, an investment would include any equity instrument 
and any debt instrument with equity features (such as conversion 
rights, warrants or call options). If the bank holding company owns or 
controls 15 percent or more of the company's total equity, the term 
also would include any other debt instrument held by the bank holding 
company or any subsidiary, except for (i) any short-term, secured 
extension of credit provided for working capital purposes, (ii) any 
extensions of credit by an insured depository institution controlled by 
the bank holding company that is collateralized in accordance with the 
requirements of section 23A of the Federal Reserve Act and that meets 
the other requirements of that section, (iii) any extension of credit 
at least 50 percent of which is sold or participated out to 
unaffiliated persons on the same terms and conditions that applied to 
the initial credit, and (iv) any extension of credit that is guaranteed 
by the U.S. Government. The capital charge would not apply to 
investments that are held in the trading account in accordance with 
applicable accounting principles and that are part of an underwriting, 
market making or dealing activity. For portfolio investments that are 
reported at cost, under the equity method, or at fair value with 
unrealized gains (or losses) included in earnings, the deduction would 
be equal to 50 percent of the carrying value of the investment. For 
available-for-sale portfolio investments reported at fair value with 
unrealized gains (or losses) included in other comprehensive income, 
the amount of the deduction

[[Page 16471]]

would equal 50 percent of the reported cost of the investment.\7\ Any 
unrealized gains on available-for-sale investments are not included in 
core capital, but may be included in supplementary capital to the 
extent permitted under section II.A.2.e of the Appendix.
---------------------------------------------------------------------------

    \7\ For available-for-sale equity investments where fair value 
is less than historical cost, the amount of the deduction is equal 
to 50 percent of reported fair value. The unrealized losses on such 
investments are deducted from core capital in accordance with 
section II.A.1.a of the Appendix.
---------------------------------------------------------------------------

    For portfolio investments in companies that are consolidated for 
accounting purposes, the deduction would equal 50 percent of the parent 
organization's investment in the company as determined under the equity 
method of accounting (net of any intangibles associated with the 
investment that are deducted from the consolidated bank holding 
company's core capital in accordance with section II.B.1 of the 
Appendix). The company would remain fully consolidated for purposes of 
determining the banking organization's risk-weighted assets.
    The total carrying value of any portfolio investment subject to the 
deduction is excluded from the bank holding company's weighted risk 
assets for purposes of computing the denominator of the company's risk-
based capital ratio. For AFS portfolio investments, this exclusion 
would apply to the reported cost or, in the case of AFS equity 
investments where fair value is less than historical cost, reported 
fair value.
    The proposal makes conforming changes to section II.b of Appendix D 
to include portfolio investments in the list of items that are excluded 
from Tier 1 capital.

Regulatory Flexibility Act Analysis

    In accordance with section 3(a) of the Regulatory Flexibility Act 
(5 U.S.C. 603(a)), the Board must publish an initial 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 enter the merchant banking 
business.
    The interim rule includes limited reporting and recordkeeping 
requirements that apply to all financial holding companies that engage 
in merchant banking, regardless of their size. The reporting and record 
keeping requirements that the rule establishes on an interim basis are 
necessary to enable the Board to execute properly its supervisory 
function and to ensure compliance by financial holding companies with 
the limitations imposed by the GLB Act on merchant banking activities. 
These statutory limits apply to all financial holding companies, 
regardless of size, engaged in merchant banking activities. The Board 
believes that the information required to be submitted or retained, in 
most cases, would be contained in routine reports to management, to 
third-party investors, or to other regulatory agencies, including the 
Securities and Exchange Commission, or would be prepared and retained 
by an organization in the normal conduct of its investment activities.
    The ability of financial holding companies to participate in the 
merchant banking business will likely enhance their overall efficiency 
and ability to compete effectively in the market for corporate 
financial services. The Board specifically seeks comment on the likely 
burden that the interim rule and proposed rule will impose on financial 
holding companies that engage in merchant banking activities and other 
financial holding companies.

Executive Order 12866 Determination

    The Department of the Treasury has determined that this interim 
rule does not constitute a ``significant regulatory action'' for 
purposes of Executive Order 12866.

Administrative Procedure Act

    The provisions of the rule are effective on March 17, 2000 on an 
interim basis. Pursuant to 5 U.S.C. 553, the Board and the Secretary of 
the Treasury find that it is impracticable to review public comments 
prior to the effective date of the interim rule, and that there is good 
cause to make the interim rule effective on March 17, 2000, due to the 
fact that the rule sets forth procedures to implement statutory changes 
that were recently enacted and that became effective on March 11, 2000. 
The Board and the Secretary of the Treasury are seeking public comment 
on all aspects of the interim rule and will amend 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 interim 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.

Paperwork Reduction Act

    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 interim rule under the authority delegated to the Board by the 
Office of Management and Budget.
    The collection of information requirements in the interim rule are 
found in 12 CFR 225.171(d)(3); 225.172, and 225.174. This information 
is required to evidence compliance with the requirements of Title I of 
the GLB Act (Pub. L. No. 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 properly exercise its supervisory responsibility for 
financial holding companies. The respondents are financial holding 
companies that choose to engage in merchant banking activities.
    The interim rule requires that a financial holding company submit 
an annual report to the Reserve Bank relating to merchant banking 
investments that have been held for an extended period of time and 
providing aggregate information on merchant banking investments (see 12 
CFR 225.174(c)(1)) and file quarterly reports with the Reserve Bank 
providing aggregate data on the company's merchant banking investments 
(see 12 CFR 225.174(c)(2)). The Board expects to publish a separate 
notice to issue reporting forms that may be used to comply with the 
annual and quarterly reporting requirements. The burden associated with 
these information collections will be addressed at that time.
    The interim rule also 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 225.174(d)). The agency form 
number for this declaration will be the FR 4018. In addition, the rule 
allows a financial holding company to seek relief from the holding 
period and aggregate investment limits imposed by the rule by filing a 
request and supporting documentation with the Board (see 12 CFR 
225.172(b) and 225.173). The agency form number for these requests will 
be FR 4019. There will be no formal reporting form for these notices 
and requests. The information may be submitted in the form of a letter. 
The Board expects to

[[Page 16472]]

receive very few of these notices and requests. The Board estimates 
that approximately 250 financial holding companies will engage in 
merchant banking activities in the first year after adoption of the 
interim rule. Of the 250 financial holding companies, the Board 
estimates that 100 will file these notices and requests and 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 would be $5000.
    The interim 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 (see 12 CFR 225.171(d)(3), 
and 225.174(a) and (b)). The Federal Reserve believes that most of 
these internal control and record keeping 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 250 financial holding companies will spend approximately 5 
hours in complying with these internal control and recordkeeping 
requirements, resulting in an estimated annual burden of 1,250 hours. 
Based on a rate of $50 per hour, the annual cost to the public would be 
$62,500.
    The Federal Reserve specifically requests comment on the accuracy 
of these burden estimates. 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 section (b)(4) and (b)(6) of the Freedom of 
Information Act (5 U.S.C. 552(b)(4) and (b)(6)).
    Comments are invited on: (a) Whether the proposed collections of 
information are necessary for the proper performance of the Federal 
Reserve's functions, including whether the information has practical 
utility; (b) the accuracy of the Federal Reserve's estimate of the 
burden of the proposed information collections, including the cost of 
compliance; (c) ways to enhance the quality, utility, and clarity of 
the information to be collected; and (d) ways to minimize the burden of 
information collections on respondents, including through the use of 
automated collection techniques or other forms of information 
technology. Comments on the collections of information should be sent 
to the Office of Management and Budget, Paperwork Reduction Project, 
Washington, DC 20503, with copies of such comments to be sent to Mary 
M. West, Federal Reserve Board Clearance Officer, Division of Research 
and Statistics, Mail Stop 97, Board of Governors of the Federal Reserve 
System, Washington, DC 20551.

Solicitation of Comments Regarding the 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 invites comments about how to make the interim rule 
easier to understand, including answers to 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 not, 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 solicits comment about whether including factual 
examples in the rule in order to illustrate its terms is appropriate. 
The Board notes that creating safe harbors in the rule may generate 
certain problems over time due to changes in technology or business 
practices. Are there alternatives that the Board should consider to 
illustrate the terms in the rule?

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 is revised to read as 
follows:

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

    2. Section 225.1 is amended by redesignating paragraphs (c)(9) 
through (c)(13) as paragraphs (c)(11) through (c)(15), respectively, 
adding and reserving a new paragraph (c)(9), and adding a new paragraph 
(c)10 to read as follows:


Sec. 225.1  Authority, purpose, and scope.

* * * * *
    (c) * * *
    (10) Subpart J governs the conduct by financial holding companies 
of merchant banking investment activities permitted under section 
4(k)(4)(H) of the Bank Holding Company Act (12 U.S.C. 1843(k)(4)H)).
* * * * *
    3. A new Subpart J is added to read as follows:
Subpart J--Merchant Banking Investments
Sec.
225.170   What investments are permitted under this subpart and who 
may make them?
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   What aggregate limits apply to merchant banking 
investments?
225.174   What risk management, reporting and recordkeeping policies 
are required to make merchant banking investments?
225.175   How do the statutory cross marketing and section 23A and 
23B limitations apply to merchant banking investments?

[[Page 16473]]

Subpart J--Merchant Banking Investments


Sec. 225.170--What  investments are permitted under this subpart and 
who may make them?

    (a) What investments are permitted under 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 a 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 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 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 shares or other ownership interests in a company, unless:
    (1) The assets are held within 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 that meet the requirements of 
Sec. 225.174(a)(4) for limiting the legal liability of the financial 
holding company; and
    (3) The portfolio company has management that is separate from the 
financial holding company to the extent required by section 
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 controls a 
company that is registered with the Securities and Exchange Commission 
as a broker or dealer under the Securities Exchange Act of 1934 (15 
U.S.C. 78a et seq.); or
    (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.
    (g) What do references to a financial holding company include? The 
term ``financial holding company'' as used in this subpart means the 
financial holding company and each of its subsidiaries, but, except for 
Secs. 225.171 and 225.174, does not include a depository institution or 
subsidiary of a depository institution. The term includes any private 
equity fund controlled by the financial holding company, but does not 
include any portfolio company controlled by the financial holding 
company.
    (h) 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 that acquires or controls, or 
is affiliated with a company that acquires or controls, merchant 
banking investments under this subpart.
    (i) What is a portfolio company? A portfolio company is any company 
or entity:
    (1) That is engaged in any activity not authorized for a financial 
holding company under section 4 of the Bank Holding Company Act; (12 
U.S.C. 1843) and
    (2) The shares, assets or ownership interests of which are held, 
owned or controlled directly or indirectly by the financial holding 
company pursuant to this subpart.


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 provided in paragraph (d) of this section, 
a financial holding company may not routinely manage or operate any 
portfolio company in which it has a direct or indirect interest and any 
portfolio company held by any company (including a private equity fund) 
in which the financial holding company has an ownership interest under 
this subpart.
    (b) What does it mean to routinely manage or operate a company? A 
financial holding company routinely manages or operates a portfolio 
company if:
    (1) Any director, officer, employee or agent of the financial 
holding company serves as or has the responsibilities of an officer or 
employee of the portfolio company;
    (2) Any officer or employee of the portfolio company is supervised 
by any director, officer, employee or agent of the financial holding 
company (other than in that individual's capacity as a director of the 
portfolio company);
    (3) 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 transactions in the ordinary course of 
business or hiring employees below the rank of the five highest ranking 
executive officers;
    (4) Any director, officer, employee or agent of the financial 
holding company, whether in the capacity of a director of the portfolio 
company, adviser to the portfolio company, or otherwise, participates 
in:
    (i) The day-to-day operations of the portfolio company, or
    (ii) Management decisions made in the ordinary course of business 
of the portfolio company other than decisions in which a director of a 
company customarily participates in that individual's capacity as a 
director; or (5) Any other arrangement or practice exists by which the 
financial holding company

[[Page 16474]]

routinely manages or operates the portfolio company.
    (c) What arrangements do not involve routinely managing or 
operating a 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 directors, 
officers, employees or agents 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 as described in paragraph (b) 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, 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, including:
    (i) The acquisition of control or significant assets of other 
companies;
    (ii) Significant changes to the business plan of the portfolio 
company;
    (iii) The redemption, authorization or issuance of any shares of 
capital stock (including options, warrants or convertible shares) of 
the portfolio company; and
    (iv) 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.
    (d) When may a financial holding company manage or operate a 
portfolio company? (1) Special circumstances required. A financial 
holding company may routinely manage or operate a portfolio company 
only:
    (i) When intervention is necessary to address a material risk to 
the value or operation of the portfolio company, such as a significant 
operating loss or loss of senior management; and
    (ii) For the period of time as may be necessary to address the 
cause of 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.
    (2) Approval required for extended involvement. A financial holding 
company may not routinely manage or operate a portfolio company for a 
period greater than six months without prior approval of the Board.
    (3) Documentation required. A financial holding company must 
maintain and make available to the Board a written record describing 
its involvement in the management or operation of a portfolio company 
and the reasons therefor.
    (e) May a depository institution or its subsidiary manage or 
operate a portfolio company? (1) In general. A depository institution 
or subsidiary of a depository institution may not under any 
circumstances manage or operate a portfolio company in which an 
affiliated company owns or controls an interest under this subpart.
    (2) Exceptions. Paragraph (e)(1) of this section does not 
prohibit--
    (i) A director, officer or employee of a depository institution or 
subsidiary of a depository institution from serving as a director of a 
portfolio company in accordance with the limitations set forth in this 
section; or
    (ii) A financial subsidiary held in accordance with section 5136A 
of the Revised Statutes (12 U.S.C. 24a) or section 46(a) of the Federal 
Deposit Insurance Act (12 U.S.C. 1831w) from taking actions in 
accordance with the limitations set forth in this section.


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. 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, except that an investment in or held through a private equity 
fund may be held for the duration of the fund.
    (2) Ownership interests acquired from or transferred to companies 
held under this subpart. For purposes of paragraph (b)(1) of this 
section, any interest in shares, assets or ownership interests--
    (i) Acquired by a financial holding company from a company 
(including a private equity fund) 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 (including a private equity fund) 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 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 investments held in excess of 
applicable time limit. A financial holding company may, in 
extraordinary circumstances, 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 applicable period specified in 
paragraph (b)(1) of this section. A request for approval must:
    (i) Be submitted to the Board no later than 1 year 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

[[Page 16475]]

the risks that disposing of the investment may pose to the financial 
holding company;
    (iii) Market conditions; and
    (iv) The extent and history of involvement by the financial holding 
company in the management and operations of the company.
    (6) Restrictions applicable to investments held beyond applicable 
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 applicable 
period specified in paragraph (b)(1) of this section must:
    (i) Deduct an amount equal to 100 percent of the carrying value of 
the financial holding company's interest in the share, asset or 
ownership interest from the Tier 1 capital of the holding company and 
exclude all unrealized gains on the share, asset or ownership interest 
from its Tier 2 capital;
    (ii) Not enter into any additional transactions, contractual 
arrangements or other relationships with the company or extend any 
additional credit to the company without Board approval; and
    (iii) Abide by any other restrictions that the Board may impose in 
connection with granting approval under paragraph (b)(4) of this 
section.
    (c) What is a private equity fund? (1) Definition of a private 
equity fund. For purposes of this subpart, a ``private equity fund'' is 
any company that:
    (i) Is formed for the purpose of and is engaged exclusively in the 
business of investing in shares, assets, and ownership interests of 
companies for resale or other disposition;
    (ii) Is not an operating company;
    (iii) Issues equity ownership interests to at least 10 investors 
that are not affiliated with, and are not officers, directors, 
employees or principal shareholders of the financial holding company;
    (iv) 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;
    (v) That has an initial term of not more than 12 years, which term 
may be extended for an additional three 1-year periods with the 
approval of persons holding a majority of the equity of the fund;
    (vi) Establishes a plan for the resale or disposition of its 
investments, and holds, owns or controls investments only for a 
reasonable period of time consistent with making merchant banking 
investments;
    (vii) Maintains policies on diversification of fund investments; 
and
    (viii) 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 contained in this subpart on merchant banking 
investments.
    (2) 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.
    (3) May a private equity fund manage a portfolio company? A private 
equity fund may not routinely manage or operate a portfolio company 
except as permitted by this subpart.


Sec. 225.173  What aggregate limits 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 it under this subpart if the aggregate 
carrying value of all merchant banking investments held by the 
financial holding company under this subpart exceeds:
    (1) The lesser of 30 percent of the Tier 1 capital of the company 
or $6 billion; or
    (2) The lesser of 20 percent of the Tier 1 capital of the company 
or $4 billion excluding interests in private equity funds.
    (b) Do these limits apply to interests held through a private 
equity fund? Paragraph (a) of this section does not prohibit any 
private equity fund that a financial holding company controls from 
acquiring shares, assets or ownership interests.


Sec. 225.174  What risk management, reporting and recordkeeping 
policies are required to make merchant banking investments?

    (a) What internal controls are necessary? A financial holding 
company, including a private equity fund controlled by the financial 
holding company, that makes investments under this subpart must 
establish and maintain policies, procedures, and systems reasonably 
designed to:
    (1) Monitor and adequately assess the value of each investment, the 
value of the aggregate portfolio, and the diversification of the 
portfolio;
    (2) Identify and manage the market, credit, concentration and other 
risks associated with merchant banking investments;
    (3) Monitor and review the terms, amounts and types of transactions 
and relationships between the financial holding company (in the 
aggregate and separately by affiliate) and each company in which the 
financial holding company has an interest under this subpart to assess 
the risks and costs of the transactions and relationships, including 
whether each transaction or relationship is on market terms, and to 
assure compliance with any provisions of law, including any applicable 
fiduciary principles, governing those transactions and relationships;
    (4) Ensure the maintenance of corporate separateness between the 
financial holding company and each company in which the financial 
holding company has an interest under this subpart, including policies, 
procedures and systems sufficient to protect the financial holding 
company and depository institutions controlled by the financial holding 
company from legal liability for the conduct of operations and for the 
financial obligations of each such company; and
    (5) Ensure compliance with the provisions of this subpart governing 
merchant banking investments.
    (b) What records must be maintained? A financial holding company 
must maintain, at a central location, records and supporting 
information that:
    (1) Are sufficient to enable the Board to review the policies, 
procedures and systems described in paragraph (a) of this section;
    (2) Detail the cost, carrying value, market value, and performance 
data for each investment made under this subpart, including investments 
made through private equity funds;
    (3) Include copies of the financial statements of any company in 
which the financial holding company holds an interest under this 
subpart, including investments made through private equity funds, and 
any information and valuations provided to any co-investors in such 
companies;
    (4) Document any transaction or relationship between the financial 
holding company and any company in which the financial holding company 
holds an interest under this subpart that is not on market terms; and
    (5) Document any contingent fee or contingent interest in a private 
equity fund or relating to any other investment held under this 
subpart, including the carrying value and market value of such fee or 
interest and the amount of such fee or interest that has been 
recognized by the financial holding company as

[[Page 16476]]

income but that is contingent on future performance or asset 
valuations.
    (c) What periodic reports must be filed? (1) Annual reports 
regarding merchant banking investments. A financial holding company 
must report annually to the appropriate Reserve Bank in such format and 
at such time as the Board may prescribe:
    (i) For each interest that the financial holding company owns or 
controls under this subpart (other than an interest in or held through 
a private equity fund) and that it has owned or controlled for a period 
that totals longer than five years as of the reporting date:
    (A) The identity of the company in which the interest is held, a 
description of the investment and, if available, a description of the 
other investors and their interests in the company;
    (B) The historical cost of the investment;
    (C) The market or other valuation of the investment as of the 
reporting date; and
    (D) The schedule for sale or disposition of the investment;
    (ii) For each interest that the financial holding company owns or 
controls under this subpart, including an interest in or held through a 
private equity fund, and that it has owned or controlled for a period 
that totals longer than eight years as of the reporting date:
    (A) A detailed explanation of the financial holding company's plan 
and schedule for the sale or disposition of the investment; and
    (B) The information required under paragraph (c)(1)(i) of this 
section;
    (iii) Aggregate data describing the number, total historical cost, 
total carrying value and total market value for merchant banking 
investments, segregated by holding period (in 2 year increments), 
geographic distribution (national or regional, as appropriate), and 
industrial sector.
    (2) Quarterly reporting for all merchant banking investments. A 
financial holding company must, within 60 days of the end of each 
calendar quarter and in the format prescribed by the Board, submit a 
report to the appropriate Reserve Bank of the total number, aggregate 
historical cost and aggregate current valuation of all investments held 
pursuant to this subpart.
    (d) Is notice required for the acquisition of companies?
    (1) Fulfillment of statutory notice requirement. Except as required 
in paragraph (d)(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 activities under this subpart.
    (2) Notice of large individual investments. A financial holding 
company must provide written notice to the Board within 30 days after 
acquiring more than 5 percent of the shares, assets or ownership 
interests of any company, including a private equity fund, at a total 
cost that exceeds the lesser of 5 percent of the Tier 1 capital of the 
company or $200 million.
    (3) Content of notice. A notice under paragraph (d)(2) of this 
section must set forth:
    (i) The cost of the investment and method for funding the 
investment;
    (ii) The percentage of Tier 1 capital that the investment 
represents;
    (iii) A description of the company and the type of investment; and
    (iv) An explanation of the risk management measures to be applied 
by the financial holding company to the investment.


Sec. 225.175  How do the statutory cross marketing and section 23A and 
23B 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 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 financial 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).
    (b) When are companies held under section 4(k)(4)(H) affiliates 
under sections 23A and 23B? (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 holds any shares, assets or 
ownership interests of a company pursuant to this subpart, the company 
shall be presumed to be an affiliate of any member bank that is 
affiliated with the financial holding company if such financial holding 
company, directly or indirectly, owns or controls 15 percent or more of 
the equity capital of the 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) Convertible instruments. For purposes of paragraph (b)(1) of 
this section, equity capital includes options, warrants and any other 
instrument convertible into equity capital.
    (4) 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 or has 
sponsored and advises the private equity fund.
    (5) Application of sections 23A and 23B to U.S. branches and 
agencies of foreign banks. Sections 23A and 23B of the Federal Reserve 
Act 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.

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

Department of the Treasury

12 CFR Chapter XV

Authority and Issuance

    For the reasons set forth in the preamble, the Department of the 
Treasury adds part 1500 to subchapter

[[Page 16477]]

A of chapter XV of Title 12 of the Code of Federal Regulations to read 
as follows:

PART 1500--MERCHANT BANKING INVESTMENTS

Sec.
1500.1   How are terms defined for purposes of this part?
1500.2   What investments are permitted under this part and who may 
make them?
1500.3   What are the limitations on managing or operating a 
portfolio company held as a merchant banking investment?
1500.4   What are the holding periods permitted for merchant banking 
investments?
1500.5   What aggregate limits apply to merchant banking 
investments?
1500.6   What risk management, reporting and record keeping policies 
are required to make merchant banking investments?
1500.7   How do the statutory cross marketing and sections 23A and 
23B limitations apply to merchant banking investments?

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


Sec. 1500.1--How  are terms defined for purposes of this part?

    Unless otherwise provided in this part, all terms used in this part 
have the meanings given such terms in 12 CFR Part 225 (Regulation Y of 
the Board of Governors of the Federal Reserve System Board).


Sec. 1500.2--What  investments are permitted under this part and who 
may make them?

    (a) What investments are permitted under 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 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 a 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 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 shares or other ownership interests in a company, unless:
    (1) The assets are held within 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 that meet the requirements of 12 CFR 
225.174(a)(4) for limiting the legal liability of the financial holding 
company; and
    (3) The portfolio company has management that is separate from the 
financial holding company to the extent required by Sec. 1500.3.
    (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:
    (1) Securities affiliate. The financial holding company controls a 
company that is registered with the Securities and Exchange Commission 
as a broker or dealer under the Securities Exchange Act of 1934 (15 
U.S.C. 78a et seq.); or
    (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.
    (g) What do references to a financial holding company include? The 
term ``financial holding company'' as used in this part means the 
financial holding company and each of its subsidiaries, but, except for 
Sec. 1500.3, does not include a depository institution or subsidiary of 
a depository institution. The term includes a private equity fund 
controlled by the financial holding company, but does not include any 
portfolio company controlled by the financial holding company.
    (h) 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 that acquires or controls, or 
is affiliated with a company that acquires or controls, merchant 
banking investments under this part.
    (i) What is a portfolio company? A portfolio company is any company 
or entity:
    (1) That is engaged in any activity not authorized for a financial 
holding company under section 4 of the Bank Holding Company Act; and
    (2) The shares, assets or ownership interests of which are held, 
owned or controlled directly or indirectly by the financial holding 
company pursuant to this part.


Sec. 1500.3  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 provided in paragraph (d) of this section, 
a financial holding company may not routinely manage or operate any 
portfolio company in which it has a direct or indirect interest and any 
portfolio company held by any company (including a private equity fund) 
in which the financial holding company has an ownership interest under 
this part.
    (b) What does it mean to routinely manage or operate a company? A 
financial holding company routinely manages or operates a portfolio 
company if:
    (1) Any director, officer, employee or agent of the financial 
holding company serves as or has the responsibilities of an officer or 
employee of the portfolio company;
    (2) Any officer or employee of the portfolio company is supervised 
by any

[[Page 16478]]

director, officer, employee or agent of the financial holding company 
(other than in that individual's capacity as a director of the 
portfolio company);
    (3) 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 transactions in the ordinary course of 
business or hiring employees below the rank of the five highest ranking 
executive officers;
    (4) Any director, officer, employee or agent of the financial 
holding company, whether in the capacity of a director of the portfolio 
company, adviser to the portfolio company, or otherwise, participates 
in:
    (i) The day-to-day operations of the portfolio company, or
    (ii) Management decisions made in the ordinary course of business 
of the portfolio company other than decisions in which a director of a 
company customarily participates in that individual's capacity as a 
director; or
    (5) Any other arrangement or practice exists by which the financial 
holding company routinely manages or operates the portfolio company.
    (c) What arrangements do not involve routinely managing or 
operating a 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 directors, 
officers, employees or agents 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 as described in paragraph (b) 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, 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, including:
    (i) The acquisition of control or significant assets of other 
companies;
    (ii) Significant changes to the business plan of the portfolio 
company;
    (iii) The redemption, authorization or issuance of any shares of 
capital stock (including options, warrants or convertible shares) of 
the portfolio company; and
    (iv) 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.
    (d) When may a financial holding company manage or operate a 
portfolio company? (1) Special circumstances required. A financial 
holding company may routinely manage or operate a portfolio company 
only:
    (i) When intervention is necessary to address a material risk to 
the value or operation of the portfolio company, such as a significant 
operating loss or loss of senior management; and
    (ii) For the period of time as may be necessary to address the 
cause of 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.
    (2) Approval required for extended involvement. A financial holding 
company may not routinely manage or operate a portfolio company for a 
period greater than six months without prior approval of the Board.
    (3) Documentation required. A financial holding company must 
maintain and make available to the Board a written record describing 
its involvement in the management or operation of a portfolio company 
and the reasons therefor.
    (e) May a depository institution or its subsidiary manage or 
operate a portfolio company? (1) In general. A depository institution 
or subsidiary of a depository institution may not under any 
circumstances manage or operate a portfolio company in which an 
affiliated company owns or controls an interest under this part.
    (2) Exceptions. Paragraph (e)(1) of this section does not 
prohibit--
    (i) A director, officer or employee of a depository institution or 
subsidiary of a depository institution from serving as a director of a 
portfolio company in accordance with the limitations set forth in this 
section; or
    (ii) A financial subsidiary held in accordance with section 5136A 
of the Revised Statutes (12 U.S.C. 24a) or section 46(a) of the Federal 
Deposit Insurance Act (12 U.S.C. 1831w) from taking actions in 
accordance with the limitations set forth in this section.


Sec. 1500.4  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. 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, except that an investment in or held through a private equity 
fund may be held for the duration of the fund.
    (2) Ownership interests acquired from or transferred to companies 
held under this part. For purposes of paragraph (b)(1) of this section, 
any interest in shares, assets or ownership interests--
    (i) Acquired by a financial holding company from a company 
(including a private equity fund) 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 (including a private equity fund) 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 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 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 investments held in excess of 
applicable

[[Page 16479]]

time limit. A financial holding company may, in extraordinary 
circumstances, 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 applicable period specified in paragraph (b)(1) of 
this section. A request for approval must:
    (i) Be submitted to the Board no later than 1 year 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; and
    (iv) The extent and history of involvement by the financial holding 
company in the management and operations of the company.
    (6) Restrictions applicable to investments held beyond applicable 
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 applicable period 
specified in paragraph (b)(1) of this section must:
    (i) Deduct an amount equal to 100 percent of the carrying value of 
the financial holding company's interest in the share, asset or 
ownership interest from the Tier 1 capital of the holding company and 
exclude all unrealized gains on the share, asset or ownership interest 
from its Tier 2 capital;
    (ii) Not enter into any additional transactions, contractual 
arrangements or other relationships with the company or extend any 
additional credit to the company without Board approval; and
    (iii) Abide by any other restrictions that the Board may impose in 
connection with granting approval under paragraph (4).
    (c) What is a private equity fund? (1) Definition of a private 
equity fund. For purposes of this part, a ``private equity fund'' is 
any company that:
    (i) Is formed for the purpose of and is engaged exclusively in the 
business of investing in shares, assets, and ownership interests of 
companies for resale or other disposition;
    (ii) Is not an operating company;
    (iii) Issues equity ownership interests to at least 10 investors 
that are not affiliated with, and are not officers, directors, 
employees or principal shareholders of the financial holding company;
    (iv) 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;
    (v) That has an initial term of not more than 12 years, which term 
may be extended for an additional three 1-year periods with the 
approval of persons holding a majority of the equity of the fund;
    (vi) Establishes a plan for the resale or disposition of its 
investments, and holds, owns or controls investments only for a 
reasonable period of time consistent with making merchant banking 
investments;
    (vii) Maintains policies on diversification of fund investments; 
and
    (viii) 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 or evading the limitations 
contained in this part on merchant banking investments.
    (2) 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.
    (3) May a private equity fund manage a portfolio company? A private 
equity fund may not routinely manage or operate a portfolio company 
except as permitted by this part.


Sec. 1500.5  What aggregate limits 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 it under this part if the aggregate carrying value 
of all merchant banking investments held by the financial holding 
company under this part exceeds:
    (1) The lesser of 30 percent of the Tier 1 capital of the company 
or $6 billion; or
    (2) The lesser of 20 percent of the Tier 1 capital of the company 
or $4 billion excluding interests in private equity funds.
    (b) Do these limits apply to interests held through a private 
equity fund? Paragraph (a) of this section does not prohibit any 
private equity fund that a financial holding company controls from 
acquiring shares, assets or ownership interests.


Sec. 1500.6  What risk management, reporting and recordkeeping policies 
are required to make merchant banking investments?

    Certain risk management, reporting and recordkeeping requirements 
for merchant banking investments are set forth in the Board's 
Regulation Y, 12 CFR 225.174.


Sec. 1500.7  How do the statutory cross marketing and sections 23A and 
23B limitations apply to merchant banking investments?

    Certain cross-marketing limitations and limitations under sections 
23A and 23B of the Federal Reserve Act applicable to merchant banking 
investment are set forth in the Board's Regulation Y, 12 CFR 225.175.

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