Most South Dakota-based community banking organizations include a bank holding company (BHC), perhaps resulting from when the organization made its first acquisition and needed outside financing to get the deal done. Regardless of why the organization chose to create a BHC, that BHC for most South Dakota banking organizations is likely to be its only point of contact with the Federal Reserve Board, the exclusive regulator of BHCs although the Federal Reserve is the primary federal regulator for only a handful of banks in South Dakota. Most South Dakota banks (national banks and state non-member banks) have the OCC or the FDIC as their primary federal regulator and thus lack a regular, active relationship with the Federal Reserve even if they have a BHC. Most community banking organizations, however, will from time to time have reason to bring their BHC into some sort of interaction with the Federal Reserve. Davenport Evans lawyer Charles D. Gullickson reflects on BHC regulatory issues in this article from Volume IV of The Bottom Line, a publication of The Independent Community Bankers of South Dakota.
Ownership of BHCs by a Trust
The owners of privately held BHCs often choose to hold their shares in trust; it might be something as simple as a revocable (living) trust with the grantor acting as trustee, followed by other arrangements to distribute the BHC shares on the death of the grantor.
When placing BHC shares in a trust it is important to remember that a “company” for BHC purposes can include a trust unless certain requirements are satisfied. Federal Reserve Board regulations implementing the Bank Holding Company Act defined “company” for BHC purposes to include “any bank, corporation, general or limited partnership, association or similar organization, business trust, or any other trust unless by its terms it must terminate either within 25 years or within 21 years and 10 months after the death of individuals living on the effective date of the trust” (see 12 CFR § 225.2(d)(1)). To avoid one’s trust becoming a BHC itself (which for most would be an undesirable result), one should make sure that any trust that owns BHC shares will terminate within 25 years after its creation or within 21 years and 10 months after the death of individuals living on the effective date of the trust. Because of how “company” is defined for BHC purposes, generally one would not put bank or BHC shares in a dynasty trust.
Note that “company” for BHC purposes also includes a business trust. Neither the Bank Holding Company Act nor its implementing regulations define the term “business trust,” but there is some risk that if a trust owns other ongoing, active businesses (in addition to BHC shares) the Federal Reserve may take a position that the trust is a “business trust” and thus a “company” for BHC purposes. Thus, if a grantor of a trust owns both BHC stock and other ongoing, active businesses, the best course of action is to create one trust for the BHC shares and a separate trust for other ongoing business activities.
Capital Adequacy Requirements and Leverage Limitations for Small Bank Holding Companies
Capital adequacy requirements are an omnipresent reality for state and national banks. “Small” BHCs, however, face a different reality. More specifically, BHCs with total consolidated assets of less than $3 billion are not subject to Federal Reserve Board capital adequacy requirements, and thus the risk-based capital requirements and leverage rules that apply to other banking organizations do not apply to BHCs with less than $3 billion in consolidated assets.
Although small BHCs are exempt from the capital adequacy requirements, that does not mean they are free from regulation of the liability side of their balance sheet. Small BHCs are subject to leverage limitations found in the Federal Reserve Board small bank holding company policy statement set forth in Appendix C to 12 CFR Part 225. Among other things, the policy statement has these limitations on leverage for a small BHC:
- The BHC may use debt to finance up to 75 percent of the purchase price for an acquisition (although in reality the Federal Reserve becomes uncomfortable with approving an acquisition where the acquisition debt gets close to 75 percent).
- When incurring debt a small BHC must be able to demonstrate that the debt can be retired within 25 years after being incurred and that it will have a debt-to-equity ratio of .3 to 1, or less, within 12 years after the debt is incurred.
- A small BHC with a debt-to-equity ratio of greater than 1.0 to 1.0 is not allowed to pay dividends unless certain criteria are satisfied.
The limitations on leverage set forth in the small bank holding company policy statement apply not only to acquisition debt but also to any other forms of debt incurred by the BHC, such as debt incurred to finance a redemption by a BHC of its own shares.
Change in Control Issues
Bankers are generally aware that a change in control of a banking organization requires prior approval from that organization’s primary regulator(s). The change in control regulations applicable to BHCs are found in 12 CFR §§ 225.41 through 225.44.
There are several nuances to the change in control requirements that one should consider including, for example, the definition of “control” for these purposes. Generally, “control” consists of the power to vote 25 percent or more of the “shares of any class of voting securities, whether directly or indirectly or acting through one or more other persons…” even if one or more other shareholders have a larger stake in the BHC (see 12 CFR § 225(e)(1)(i)). Under these rules “control” also exists if a person has the ability to exercise a controlling influence over the management or policies of a bank or BHC or if a person is “acting in concert” with other persons – and it is noteworthy that a person will be deemed to be “acting in concert” with other members of his or her immediate family.
The change in control requirements apply to not only voluntary, intentional acquisitions of control but also to what one could refer to as an involuntary acquisition of control, such as a receipt of bank or BHC shares through a gift or by inheritance. Unlike voluntary acquisitions of control, which require prior regulatory approval, prior approval is not required for involuntary acquisitions of control. Instead, one who acquires control of a banking organization through a gift, inheritance, or other similar transaction must file the appropriate notice of change of control within 90 days after the event which caused that person to acquire control of the banking organization.