A Primer On Permissible Activities For Bank Holding Companies

October 22, 2015 | dehs

ICBSDtestBy Charles D. Gullickson

As published in the Independent Community Bankers of South Dakota newsletter, October 2015 edition.  Sign up for ICBSD e-news here.

According to the Federal Reserve, nearly three-quarters of community banks are owned by a bank holding company. Although there are numerous reasons why so many community banks opt for a holding company structure (including tax benefits if ownership is carrying debt for the acquisition of its subsidiary bank), one potential reason (and benefit) is that a holding company is generally permitted to engage in a wider range of non-banking investments and activities than its subsidiary bank. Nonetheless, as explained below, the activities of bank holding companies remain restricted by the Bank Holding Company Act or, if the holding company has elected to become a “financial holding company,” by the Gramm-Leach-Bliley Act. Thus, holding companies need to evaluate all potential investments—and monitor existing investments—to avoid regulatory issues.

The Bank Holding Company Act

The corporate practices and investment activities of bank holding companies and their subsidiaries are controlled by the Bank Holding Company Act of 1956 and Regulation Y. As a general rule, the Act prohibits a bank from engaging in activities other than activities deemed to be “closely related to banking.” Regulation Y contains a laundry list of nonbanking activities that are deemed closely related to banking and thus permissible. Moreover, in addition to the activities listed in Regulation Y, the Federal Reserve has authority to approve additional activities on a case-by-case basis. Thus, as a general matter, bank holding companies do have broad authority to make a wide array of investments.

The fact that holding companies do have such broad authority could lead a holding company to incorrectly assume that, similar to a nonbanking organization, it can engage in essentially any investment or activity it seems fit. However, a variety of business activities and investments remain impermissible. For example, Regulation Y provides that insurance premium funding, certain underwriting of life insurance, real estate brokerage services, real estate syndication, management consulting, and property management are not closely related to banking.

The Bank Holding Company Act and Regulation Y also contain a controversial (and confusing) limitation on a holding company’s insurance activities. In brief, a holding company is prohibited from engaging in insurance agency activity unless the holding company or a subsidiary engages in the activity at a location in a town with a population of 5,000 or less.

Gramm-Leach-Bliley and Financial Holding Companies

The Gramm-Leach-Bliley Act of 1999 somewhat resolved the confusing insurance restriction by creating a new type of holding company labeled a financial holding company. A financial holding company is permitted to engage in insurance agency activity (regardless of population). In addition, a financial holding company is permitted to engage in all activities permissible for traditional bank holding companies under the Bank Holding Company Act and Regulation Y as well as additional activities that are “financial in nature.”

Once again, there is a laundry list of activities that are considered financial in nature. Most notably, in addition to insurance activities, a financial holding company is permitted to engage in “merchant banking.” Merchant banking does not have a regulatory definition, but has been interpreted to include a wide array of non-banking investment activity, including many venture capital investments.

In order to take advantage of the expanded activities, a holding company must specifically elect to become a financial holding company. The process for electing financial holding company status is relatively simple. No specific form or examination process is required. Rather, a holding company submits a written declaration to the Federal Reserve providing that the bank holding company elects to be a financial holding company and includes various representations and certifications regarding the holding company’s capitalization and management. A holding company gains financial holding company status effective the 31stcalendar day after the date the declaration is received by the Federal Reserve (unless the Federal Reserve notifies the holding company otherwise). Given the relative simplicity of the process, electing financial holding company status is often an attractive option if a bank holding company desires to expand into an area prohibited by the Bank Holding Company Act but permitted by Gramm-Leach-Bliley.

Examples

It is important to emphasize that all bank holding company investment and activities must be authorized. Moreover, for both holding companies and financial holding companies, even permissible activities can become impermissible if the holding company does not properly limit its activity. Thus, it remains important that holding companies evaluate both ongoing and new activities and investments to ensure the holding company can engage in the activity or hold the particular investment. Below we have highlighted a few examples that illustrate the fine line between a permissible activity and impermissible activity and the distinction between activities permitted for traditional holding companies and the activities permitted for financial holding companies.

Real estate. A holding company can engage in a variety of real estate activity. For example, a holding company can provide real estate appraisals and escrow and settlement services. In addition, a holding company can acquire real estate (1) through foreclosure (for a limited period of time) and improve the property if necessary to minimize a potential loss on the sale of the property and (2) for future use by a subsidiary bank. However, a holding company cannot engage in property management, provide brokerage services, and importantly, purchase property for speculative purposes such as a general investment or for development and resale.

Insurance activities. Unless the holding company is operating in a town with less than 5,000 people, the holding company generally cannot sell insurance. However, if the holding company elects to become a “financial holding company” it is not subject to this restriction and is permitted to sell insurance even if the holding company is operating in a town of 5,000 or more.

Investments in a nonbanking company. A holding company is generally prohibited from purchasing or controlling 5% or more of a nonbanking company unless the investment is in a small business investment company (as defined and approved by the Small Business Administration) or the investment is a “qualified” community development investment. However, a financial holding company is permitted to engage in “merchant banking” which authorizes financial holding companies to hold larger ownership interests in nonbanking companies provided certain restrictions are complied with. In other words, financial holding companies have much more latitude to make non-banking equity investments.

Conclusion

Although it is true that holding companies can engage in a wide variety of activities, such activities are not unlimited. Making or holding an impermissible investment can lead to both regulatory issues and even mandatory divestment.

A holding company can potentially provide itself with greater flexibility by electing to become a financial holding company. Nonetheless, even the activities of a financial holding company remain restricted. Thus, all holding companies need to evaluate potential investments and monitor current activities to ensure permissibility and avoid regulatory issues.

Davenport, Evans, Hurwitz & Smith, LLP, located in Sioux Falls, South Dakota, is one of the state’s largest law firms. The firm’s attorneys provide business and litigation counsel to individuals and corporate clients in a variety of practice areas. For more information about Davenport Evans, visit www.dehs.com.