The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (Federal Banking Agencies) on December 27, 2019 provided temporary relief from Regulation O for banks and certain fund complexes with respect to extensions of credit to certain portfolio companies.1
The relief will be helpful to investment advisers to large fund complexes that, through the aggregated holdings of their fund clients and other accounts, own 10 percent or more of a class of voting securities of a bank or bank holding company.
Section 22(h) of the Federal Reserve Act and Regulation O thereunder place quantitative restrictions on loans made by banks to bank insiders and their related interests. Specifically, Regulation O: requires prior approval by a bank’s board of directors for extensions of credit to insiders (and their related interests) that exceed certain individual and aggregate limits; and prohibits extensions of credit to such persons beyond certain limits, regardless of prior board approval.2
Monitoring compliance with Regulation O has become challenging in recent years for banks under certain circumstances where the borrower is a portfolio company of a large fund complex,3 because of the definitions of “insider” and “related interests” under Regulation O. Regulation O defines an insider to include “an executive officer, director, or principal shareholder, and includes any related interest of such a person.” A “principal shareholder” is defined as “a person ... that directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote more than 10 percent of any class of voting securities of a member bank or company.” Further, a “related interest” of a person includes “a company that is controlled by that person,” where control is presumed when a company owns or has the power to vote 10% or more of a class of voting securities of another company. For purposes of these calculations, the holdings of the entire “fund complex” (i.e., an adviser and all of the funds and accounts over which the investment adviser has investment discretion) must be aggregated.4
Accordingly, a fund complex that controls or has the power to vote 10% or more of a class of voting securities of a bank or bank holding company becomes a “principal shareholder” of the bank or bank holding company under Regulation O. In turn, every other portfolio company that the fund complex controls, or has the power to vote, in the aggregate, 10% or more of a class of the portfolio company’s voting shares, is deemed to be a “related interest” of that principal shareholder fund complex. Under these circumstances, Regulation O would require banks to monitor extensions of credit to each such portfolio company as a related interest of the principal shareholder fund complex for compliance with Regulation O.
Given the broad implications of a strict reading of Regulation O, the Federal Banking Agencies issued temporary relief while they consider how best to permanently address the issue through rulemaking.5 The temporary relief states that the Federal Banking Agencies “would not take action against banks or principal shareholder fund complexes with respect to extensions of credit by banks to fund complex-controlled portfolio companies that otherwise would violate Regulation O,” provided the following conditions are met:
With respect to a fund complex, the fund complex as a whole does not:
- “directly or indirectly control 15 percent or more of any class of voting securities of the bank;”
- “have or seek to have any representative serve as an officer, agent or employee of the bank;” and
- “exercise or attempt to exercise a controlling influence over the management or policies of the bank, including attempting to influence the dividend polices, loan, credit, or investment decisions or policies, pricing of services, personnel decisions, operations activities, or any other similar activities or decisions of the bank.”6
With respect to the bank, “the bank does not knowingly make an extension of credit to a fund complex-controlled portfolio company, unless the terms of such extension of credit are on substantially the same terms as those prevailing for comparable transactions with unaffiliated third parties and [the extension of credit does] not involve more than normal risk of repayment or present other unfavorable features.”7
Notably, the temporary relief is limited to extensions of credit to portfolio companies of principal shareholder fund complexes and not to extensions of credit to the fund complex itself. In addition, the temporary relief does not extend to fund complexes with investment advisers that are “affiliated with a bank holding company or savings and loan holding company.” The temporary relief also does not extend to extensions of credit to portfolio companies that may be insiders of the bank for reasons other than being a portfolio company of a fund complex principal shareholder.
The temporary relief will be in effect until January 1, 2021, unless extended by the Federal Banking Agencies.
The temporary relief seeks to address a compliance burden related to monitoring underlying holdings of principal shareholders, which can be a daunting task if the principal shareholder is a fund complex. It is unclear whether the Federal Banking Agencies will take permanent action through rulemaking in the near term or seek to extend the temporary relief. Until such time as the Federal Banking Agencies take permanent action, the Interagency Statement provides temporary comfort to principal shareholder fund complexes with regard to the risk of a potential violation of Regulation O in connection with loans made to related interests of the fund complex.
1) See Interagency Statement Regarding Status of Certain Investment Funds and their Portfolio Investments for Purposes of Regulation O and Reporting Requirements under Part 363 of FDIC Regulations, Federal Reserve Board Supervision and Regulation Letter, SR 19-16 (Dec. 27, 2019) (Interagency Statement).
2) See 12 U.S.C. § 375b and 12 C.F.R. part 215 (state-chartered banks) and 12 C.F.R. part 31 (applying Regulation O to national banks and federal savings associations). Under Regulation O, any loan made to an insider of the bank must, as compared to loans made to non-bank insiders: (i) be made “on substantially the same terms (including interest and collateral),” (ii) be under the same credit underwriting standards, and (iii) be no riskier or present terms that are more favorable to the insider. Regulation O also requires certain loans to be pre-approved by the bank’s board of directors, and sets certain thresholds on loan amounts to bank insiders and their related interests.
3) The Interagency Statement defines “fund complex” to include “investment funds and institutional accounts that invest in voting securities of banking organizations ... together with the company that sponsors, manages, or advises them ....”
4) See 12 C.F.R. § 215.2(c)(1) & (2). Regulation O attributes presumptive “control of a company or bank” to a person who “owns, controls, or has the power to vote” 10% or more of a class of voting securities. Although investment advisers are not deemed to “own” the portfolio securities of their fund clients, they would be deemed to “control” the securities in their fund clients’ portfolios to the extent they have the contractual authority to: make investment decisions and control the disposition of their clients’ portfolio securities; or vote their fund clients’ portfolio securities.
5) The Federal Banking Agencies noted in the Interagency Statement they have become aware that a strict reading of Regulation O “could require the sudden and disruptive unwinding of substantial pre-existing lending relationships and reduce credit availability to a wide swath of financial and non-financial companies.”
6) The Interagency Statement indicates that the Federal Banking Agencies will presume that a fund complex satisfies these conditions if the fund complex: “(1) has provided passivity commitments to the [the Federal Reserve Board] in connection with a legal opinion issued by the Board’s General Counsel, (2) has provided a rebuttal of control to the OCC, or (3) has entered into a passivity agreement with the FDIC, in each case permitting the fund complex to directly or indirectly acquire up to 15 percent of the shares of a bank without making a filing under the Change in Bank Control Act, Bank Holding Company Act, or Home Owners’ Loan Act ....”
The presumption of compliance alluded to in the Interagency Statement stems from relief that many large fund complexes have sought and received from the Federal Banking Agencies in connection with the requirement under the Change in Bank Control Act (CBCA) to seek prior approval of the appropriate Federal Banking Agency before acquiring control of 10% or more of a class of voting securities of a bank or bank holding company. The relief that certain large fund complexes have received allows their respective funds and accounts to acquire, in the aggregate, up to 15% of a class of voting securities of a bank or bank holding company without having to make a filing under the CBCA, provided certain conditions are met.
7) Interagency Statement at 2.