May 15, 2000

Ms. Jennifer J. Johnson
Secretary
Board of Governors of the
Federal Reserve System
20^th Street and Constitution Ave., NW
Washington, DC 20551

Merchant Banking Regulation
Office of Financial Institution Policy
U.S. Department of the Treasury
1500 Pennsylvania Ave., NW, Room SC 37
Washington, DC 20220

RE: Merchant Banking Proposals, Docket Nos. R-1065 and R-1067, 65 Federal Register 16460, 16480 (March 28, 2000).

Dear Ms. Johnson and Sir or Madam:

The ABA Securities Association ("ABASA") appreciates the opportunity to comment on the interim rule jointly proposed by the Board of Governors of the Federal Reserve System ("Board") and the Department of the Treasury ("Treasury"), and the proposed rule published for comment by the Board. Both the interim and proposed rules address merchant banking activities, an important new authority granted to financial holding companies ("FHCs") by the Gramm-Leach-Bliley Act, Pub. L. No. 106-102 ("the Act" or "the statute").

ABASA is a separately-chartered subsidiary of the American Bankers Association ("ABA"), formed in 1995 to develop policy and provide representation for those holding companies involved in securities underwriting and dealing, proprietary mutual funds and derivatives activities. As the Board and Treasury know, ABASA has worked long and hard over the last five years to play a contributing role with respect to many of the securities and capital markets provisions of the Act.

I. SUMMARY

Many of ABASA's members regard the authority to engage in expanded merchant banking activities as the single most important feature of the Gramm-Leach-Bliley Act. One of the clearly-stated purposes of the legislation was to create a two-way street among all financial services providers. As a result, ABASA has a vested interest in ensuring that its members are able to engage in merchant banking activities to the full extent of both the letter and intent of the Act.

Unfortunately, the interim and proposed rules undermine, in many important respects, Congressional intent and, in effect, rebuild many of the barriers among financial services firms that Congress sought to eliminate. Further, the proposed rules are not necessary to protect the safety and soundness of the banking system or to control risk to depository institutions. Accordingly, ABASA strenuously objects to the proposed rules.

As discussed below, ABASA has numerous concerns and suggestions with respect to particular aspects of the proposed rules, but its opposition to the proposals centers on three of the regulatory restrictions. ABASA is particularly opposed to:

Ø The fifty percent capital charge applicable to all merchant banking activities;

Ø The aggregate investment limits on all newly authorized merchant banking activities; and

Ø The unnecessary and burdensome regulatory restrictions imposed on merchant banking activities conducted through private equity funds.

II. GENERAL COMMENTS

A. THE PROPOSED REGULATORY RESTRICTIONS UNDERMINE CONGRESSIONAL INTENT.

New Section 4(k)(7) of the Bank Holding Company Act authorizes the Board and Treasury to issue regulations implementing the merchant bank authority granted to affiliates of securities firms under new Section 4(k)(4)(H). By contrast, the regulatory restrictions referenced in the summary above extend well beyond implementing the merchant banking provisions of the Act.

As the Board and Treasury are aware, the Act conditions a financial holding company's ability to engage in merchant banking activities on (1) the depository institution not holding the ownership interests acquired, (2) the ownership interests acquired being held for the purpose of appreciation and ultimate resale or disposition of the investment, and (3) the holding company not engaging in the routine management or operation of the company or entity, except as may be necessary to obtain a reasonable return on the investment upon disposition. These three conditions were included in order to maintain the separation between banking and commerce.

ABASA submits that neither the capital charge, the aggregate investment limits nor the restrictions on private equity funds implement the statute's objective of ensuring that FHCs may engage in merchant banking activities but not engage in commerce. Rather, we believe that these restrictions, in all likelihood, will unduly interfere with the ability of financial holding companies to engage in merchant banking - an activity specifically authorized as financial-in-nature by the Congress.

The legislative history describing Section 4(k)(4)(H) indicates that the Congress intended that those investment banking firms affiliated with securities firms and insurance companies that opt to become financial holding companies should be permitted to continue to engage in merchant banking activities in substantially the same manner as had always been permitted.⁽¹⁾ Conversely, Congress also intended that bank holding companies should not be placed at a competitive disadvantage to investment banking firms that are unaffiliated with any depository institution; but should be allowed to engage in merchant banking activities to the same extent as non-bank affiliated investment banking firms.⁽²⁾

Despite Congress' stated intentions, the regulatory restrictions imposed by the proposed rules will effectively guarantee that a two-way street is unattainable. Securities firms will opt not to become FHCs because the price, in terms of limits on current and future merchant banking activities, is too steep. Foreign banks will conduct their merchant banking operations from offshore locales in order to avoid the draconian effects of the proposed rules. Bank and financial holding companies will be precluded from engaging in merchant banking activities on the same terms and conditions as their non-bank affiliated competitors.

ABASA also reminds the regulators that never, in all the years that financial modernization legislation was under consideration by the Congress, had there ever been any discussions about attaching capital charges, aggregate investment limits or other similarly restrictive measures to the merchant banking authority. Indeed, we are confident that if anything like the onerous capital charge or aggregate investment limits suggested in the rules had been proposed at the legislative stage, the ABASA Board of Directors would have opposed, rather than supported, the legislation.

The statutory provisions generally prohibiting FHCs from routinely managing portfolio investment firms and from holding these investments indefinitely more than adequately address the separation between banking and commerce. In addition, Sections 23A and 23B restrictions on transactions between depository institutions and their affiliates and the Act's additional provisions restricting depository institutions and portfolio investment firms from cross-marketing⁽³⁾ each others' products act as a further separation of banking from commerce. The Board and Treasury should do no more than effectuate Congressional intent.

B. THE ACT ADEQUATELY ADDRESSES SAFETY AND SOUNDNESS CONCERNS.

These regulatory restrictions are not necessary to protect the safety and soundness of depository institutions. The Congress has more than adequately addressed any safety and soundness concerns by prohibiting merchant banking activities from being conducted through a bank or bank subsidiary, for at least the first five years. Congress' approach is the only uniform, across-the-board manner in which safety and soundness reasonably can be addressed. All other concerns about safety and soundness can and should be addressed through the supervisory approach. Such an approach avoids a "one-size-fits-all" solution in favor of remedies tailor-made to the particular institution and concern sought to be addressed.

Moreover, additional regulatory restrictions adopted in the name of safety and soundness could have the unintended effect of actually increasing risk for some firms. For example, a firm without a long history of experience in merchant banking might choose to limit its merchant banking activities to more "run-of-the-mill" types of activities until sufficient expertise and comfort had been acquired. Examples of these types of activities include providing mezzanine financing or taking a small stake in a private equity fund. Many established firms provide mezzanine financing, which provides a lower return and associated lower risk. An onerous regulatory capital charge such as that contained in the instant proposal might encourage a firm to shift its investment activities away from mezzanine financing and other less risky investments toward traditional direct equity investments in order to achieve the higher returns necessary to justify the expense associated with a 50% capital charge. Similarly, the aggregate investment limitation might encourage firms to allocate limited investment capital to riskier investments in order to achieve the highest return on that limited resource.

C. RISK IS CONTROLLED THROUGH EXISTING STATUTORY REQUIREMENTS AND INTERNAL MANAGEMENT SYSTEMS.

Finally, the referenced regulatory restrictions are unnecessary to control risk. In authorizing merchant banking activities, Congress recognized the essential role merchant banking plays in modern finance⁽⁴⁾ and determined that the risk associated with these activities was acceptable. After all, only firms with well-capitalized and well-managed banks could exercise these new activities. It is inappropriate for the Board and Treasury now to second-guess that determination and raise additional barriers to full entry into merchant banking.

No evidence exists that FHCs cannot control risks associated with merchant banking activities. The banking industry has a long history of engaging in merchant banking activities through small business investment company ("SBIC") firms, through Regulation K affiliates, and under the authority of sections 4(c )(6) and 4(c )(7) of the Bank Holding Company Act.⁽⁵⁾ To date, those activities have produced strong returns with minimal losses and have taken place over a relatively long period of time, involving both expansionary and recessionary markets.

The Board and Treasury have not cited any instance in which a bank holding company was unable to manage the risks associated with merchant banking activities. More importantly, no evidence exists to suggest that FHCs exercising the new authority to engage in increased merchant banking activities will engage in activities that are any more risky. ABASA would suggest that before adding onerous regulatory restrictions in the name of controlling risk, the Board and Treasury should make a supportable and substantial demonstration of the inadequacy of the industry's current risk management systems.

In fact, rather than control risk, the regulatory restrictions imposed by the proposal could exacerbate risks to financial holding companies. Risk management involves, in part, diversification of product offerings and income streams. Some ABASA members have previously provided the Board with data demonstrating the significant contributions limited merchant banking activities have made to bank holding company revenues.⁽⁶⁾ The regulatory restrictions proposed for both existing and newly-authorized merchant banking activities will surely diminish the positive contribution these activities have made, and can make in the future, to the profitability of bank and financial holding companies.

Finally, merchant banking activities serve an important function in providing needed capital to corporations. While it is true that some of the target companies are "start-up," entrepreneurial firms, many others are not. For example, many banking organizations anticipate using the new merchant banking powers to facilitate the transfer of family-owned businesses from one generation to another. It is ABASA's strong belief that the proposed rules, if adopted, will have a very negative impact on the flow of capital to many of these small and medium-sized companies.

III. SPECIFIC COMMENTS

A. THE CAPITAL PROPOSAL.

The Board proposes to amend its regulatory capital guidelines for FHCs and bank holding companies ("BHCs") as to the treatment of certain investments in nonfinancial companies by imposing a 50 percent capital charge (deducted from Tier I capital of the BHC) on all investments made by a holding company, directly or indirectly, in nonfinancial companies. This treatment would extend to all investments made under new and existing merchant banking authority. ABASA strongly opposes this proposal. ABASA believes that there are other approaches, set out below, to the regulation of merchant banking by the Board that are superior to the draconian capital charge.

1. The Proposed Capital Charge.

A 50 percent capital charge on all merchant banking investments in nonfinancial companies is excessive. For example, under current capital guidelines if a well-capitalized BHC made an additional $100 million in nonfinancial company investments, it would need to add $6 million in Tier I capital to maintain its same well-capitalized position. Under the proposal, however, the holding company would have to deduct $50 million from its Tier I capital and replace it to maintain its same well-capitalized position. The Board proposes to require more than eight times the capital for new merchant banking activities than is currently required. Even more striking is the fact that the proposal would take existing investments previously considered by the Board to be well-capitalized at 10 percent (those in SBICs, in subsidiaries of holding companies or made under the Board's Regulation K) and apply the new capital treatment to these investments as well. This has the incongruous effect of raising members' overall capital requirements - quite significantly in some instances - without the members even exercising any new merchant banking authority under the Act.

The Board has arrived at this excessive capital proposal perhaps through a misunderstanding of industry practice in internal allocation of economic capital. The Board states that it conducted reviews of banks' own internal allocations of capital and found that investments are supported by a capital allocation of 25 percent to 100 percent of the investment, depending upon the types of investment activity. Therefore the Board justifies a 50 percent capital charge as fair, and possibly even modest. But economic capital models are not used solely to manage risk. They are also used for management information and profitability measurement. ABASA believes that when the Board takes a single component of a bank's internal capital model (or risk adjusted return on capital "RAROC" model) and grafts it onto the Board's current risk-based capital guidelines, the Board makes a serious conceptual error that has resulted in a proposal requiring excessive capital.

Economic capital models have been developed by banks primarily to provide management with the tools to analyze the economic capital necessary to support each of their businesses (not their individual portfolio investments) and to determine the amount of capital required by the institution as a whole. The model assesses capital for two purposes: risk management and performance evaluation. For risk management, the goal is to determine how to optimize the bank's overall use of capital. This analysis includes an estimation of the risk of each business unit and the contribution of that unit's risk to the overall risk of the bank. The performance evaluation aspect measures the risk-adjusted rate of return of a particular activity and the economic profit of each business unit. The objective is to measure a business unit's contribution to shareholder value and to provide a way to budget capital and determine compensation of business unit personnel. Economic capital models are used now to evaluate product categories, customer segments and incentive compensation programs. All of these uses are qualitatively different from the purpose and measurement of regulatory capital. Assessing the risk associated with merchant banking (regulatory capital requirements) is a far different process than doing resource analysis to measure business performance and thus determine the economic capital to allocate to merchant banking (economic capital allocation).

Additionally, economic capital allocation models are fine-tuned by banks on a continuing basis, as many factors change and as the model itself is changed. Economic capital models permit adjustments and allocation among asset classes so long as the overall total capital satisfies regulatory capital requirements. By contrast, the Board's proposal precludes such fine tuning and by definition becomes inaccurate. The effect is evident in the current risk-based capital ("RBC") guidelines. Board staff have freely acknowledged in the recent past that the current risk-based capital guidelines are inadequate: they overestimate the capital required for some assets and underestimate the capital required for others. However, the process for amending the regulatory capital guidelines is cumbersome and time-consuming. A regulatory capital model tends to be too inflexible for the dynamic risk it is crudely attempting to model. The Board's proposal perpetuates and exacerbates these problems instead of addressing them.

The Board's proposal severely unbalances the capital guidelines by making no adjustments for assets on which regulatory capital requirements are too high while selectively removing a category of assets for which the Board believes the regulatory capital requirements are too low and applying a completely different and much higher capital charge than would otherwise apply. This cherry-picking of capital components with no regard for the whole mix of assets subject to current risk-based capital requirements does not make for good regulatory policy. When looking at the holding company's capital requirement as a whole, the cherry-picking merely results in an excessive capital requirement for merchant banking and other investment activities.

The Board preemptively suggests in its discussion that the proposed capital charge will have no practical impact on financial holding companies, as they will remain well-capitalized. ABASA believes that the impact of these proposed changes will be much more significant than the Board suggests:

a) Bank holding companies maintain capital well in excess of well-capitalized levels in order to assure that any adverse regulatory consequences of a less than well-capitalized status do not occur due to sudden and unforeseen events. Examples might include unanticipated losses, changes in accounting rules, or sudden changes in regulatory interpretations or previous guidance. Companies take this approach in order to maintain opportunities to grow or add new activities even if there are some unanticipated losses or other short-term reductions in capital activities.

This cushion will be seriously depleted by the Board's proposal. In order to maintain the operating room required to engage in a global financial services business, institutions will need to restrain growth or refuse new opportunities until they have restored the operating cushion to a level that they have so carefully sought to create. It is impossible to quantify these lost opportunities or the drag on operations that restoring that cushion will cause. But the difficulty in quantifying them prospectively does not diminish their significance. Until the cushion is restored, the holding company's ability to make new investments or even repurchase its own stock could be severely limited.

b) It is our members' experience that, until these capital cushions are replaced, the Board itself will discourage the companies from expanding their banking and nonbanking activities. The Board correctly states that the Act's well-capitalized requirements do not apply to holding companies but only to their depository institution subsidiaries. Nonetheless, the Board has a history of carefully monitoring BHC capital levels and requiring more capital in connection with any application for an acquisition. As evidence that the Board's concern with holding company capital is undiminished, we note that the Board carefully maintains its right to deny FHC status to a BHC even if all of its depository institutions are well-capitalized and well-managed.

c) ABASA believes that the Board overlooks, or seriously underestimates, the impact of its proposal in the market. The strength of the holding company's share price is crucial for expanding business lines and "growing the business." The market expects holding companies to maintain regulatory capital levels significantly above well-capitalized and it is that margin that the Board's proposal so drastically affects. As a consequence, the market will demand that holding companies further increase their capital levels. The Board's assertion that the capital charge will not have a practical impact on those firms seems patently unsupportable.

d) Finally, ABASA believes that the Board ignores the impact of its proposal on existing investments. By applying the new capital treatment to existing investments, the Board quite probably will render uneconomic some investments previously made through SBICs or Regulation K firms or under authority of Sections 4(c)(6) or 4(c)(7) of the BHCA. These investments would become uneconomic not because of any change in inherent worth but solely because of an unanticipated change in regulatory treatment. It is unclear whether these investments will be sold, liquidated or otherwise treated differently.

In sum, ABASA believes that the Board should not attempt to fashion an illogical hybrid by cherry-picking pieces from current risk-based capital guidelines on the one hand and a small part of banks' RAROC models on the other hand. The Board is proposing to use just one component of banks' internal models to raise capital requirements without any consonant reduction of capital pertaining to other assets that would be suggested by these same internal models. By using only one component of banks' internal models, the Board merely aggravates the imbalances of the current RBC system, yielding a piecemeal, arbitrarily-selective approach to RBC reform that will result only in exaggerating the problems of the present RBC system.

2. Alternatives to the Board's Proposal.

Current RBC guidelines are in the process of being revised, according to the consultative papers from the Bank of International Settlements' Bank Supervision Committee. In that context, banking supervisors, including the Board, appear to be moving towards a greater reliance on banks' internal models in place of the poorly graduated risk categories of the current guidelines.

Regulators have a precedent for such an approach in their 1997 adoption of market risk capital. Only banks that have trading activity in excess of 10 percent of assets, or $1 billion or more, are subject to the additional capital requirements. Banks subject to the market risk capital provisions must use their internal models to calculate their market risk, subject to a requirement for "backtesting" the models against the real world performance. Certain additional requirements, used as a risk control unit independent of the business trading units and reporting directly to management, also apply. Failures of the model are addressed by case-by-case requirements of additional capital in line with the significance of the error of the model.

ABASA recommends that the Board adopt a conceptually similar approach to the regulation of merchant banking. Fortunately, the Basel Capital Accord does not apply to bank holding companies or financial holding companies. Consequently, the Board is free to test new approaches to capital adequacy at the FHC level prior to applying any new approaches at the bank level, which may be an important source of experience in developing a new International Capital Adequacy Framework.

Accordingly, as with the market risk capital provisions, ABASA recommends that the Board adopt a supervisory approach to any special capital requirements for merchant banking activities. FHCs generally would be required to meet appropriate qualitative standards for managing merchant banking risk in order to qualify for the supervisory approach. In assessing whether an FHC is appropriately managing risk under this approach, the regulators would look at all relevant facts and circumstances, including internal capital allocation models, valuation policies, reporting systems, equity investment risk management policies, and so forth. An FHC's internal capital allocation model could be used to measure and "backtest" capital adequacy with respect to merchant banking investments in a manner that could be readily monitored and validated by the supervisor. As with the market risk approach, significant failures of the model could result in additional capital requirements for merchant banking investments, on a case-by-case basis.

For FHCs that do not qualify for the supervisory approach, a more standard "across-the-board" type of approach could be used, though one that is more reasonable than the proposed 50 percent capital deduction. For example, special merchant banking capital requirements would only apply where an FHC's merchant banking investments constituted a significant proportion of the FHC's portfolio, e.g., where the investments exceed 20 percent of Tier I capital. Where special capital requirements would apply, they should be imposed at a more measured level than the 50 percent deduction and should blend with the current risk-based capital framework. ABASA believes this could be achieved with adjusted Basel risk weights of 200 percent, applied only to the incremental amount of investments that exceed the 20-percent-of-Tier I-capital threshold.

Whatever alternative might be chosen for FHCs that cannot use the supervisory approach, it should not impose any additional capital requirement on equity investments that are permissible under the Bank Holding Company Act for all bank holding companies or that are permissible for their subsidiary institutions. SBIC investments, non-controlling investments, and investments under Regulation K have all been conducted prudently and profitably by BHCs for many years. There is simply no evidence that additional capital is warranted.

If, however, the Board does choose to apply new, additional capital requirements on these investments, there must be a grandfather of the equity investments previously made under existing authorities, exempting them from retroactive capital increases. To retroactively increase requirements will completely alter the business analysis that suggested the investments were reasonable to begin with.

3. Other Capital Issues.

While ABASA opposes the Board's proposal to impose punitive capital requirements on traditional merchant banking investments, ABASA is also particularly concerned with that aspect of the proposal that treats debt as equity. Specifically, the Board proposes to apply the 50 percent capital charge to any debt instrument with equity features and all other debt if the BHC owns as little as 15 percent of the portfolio company's equity. The net effect of this treatment is to require that most loans be capitalized at 6 percent Tier I capital, while some will be subject to a 50 percent Tier I capital deduction.

ABASA objects strongly to treating debt as equity on the basis of a minor equity ownership. The proposal ignores the lower risk profile of a debt instrument that is associated with its priority in the capital structure. For merchant banking activities authorized under Regulation K, the Board only applied this treatment to subordinated debt, i.e. debt that has been contractually lowered in payment priority to an equity position. While different treatment of subordinated debt compared to senior debt may make sense, this proposed treatment of unsubordinated debt does not.

Additionally, we note that if the Board chose to evaluate the treatment of such debt by banks' internal capital models, it would find that the models rarely apply a 50 percent capital deduction to debt with equity features and are even less likely to apply it to senior loans to portfolio companies. In most cases, the credit analysis and the decision to make the loan would be conducted by an entirely different department within the FHC.

This treatment of debt as equity further exacerbates the competitive disparity between domestic FHCs and other investment banking firms and foreign banks. It also appears to have a disproportionate impact on smaller firms seeking capital. These firms are much more likely than large firms to have an existing credit relationship with the FHC or one of its depository institutions. The debt relationship will be damaged, or the likelihood of receiving an equity investment will be diminished. Either way, small businesses are likely to suffer a decrease in the availability of capital and/or a significant increase in their costs of debt, since banks are the major providers of small business lending.

While ABASA believes it is inappropriate to treat debt as equity, should the Board determine to go forward with its proposal, exceptions to the proposal need to be modified. For example, ABASA suggests that short-term working capital loans should all be exempt, whether collateralized or not. The Board provides an exception for loans at least 50 percent of which are participated out of the institution. Presumably the Board allows this exception because the purchase of the loan by another unaffiliated institution demonstrates the arm's-length nature and validity of the loan. Would not any purchase of a significant portion of the loan demonstrate the same thing?

B. AGGREGATE INVESTMENT LIMITS.

The interim rule establishes two aggregate limits on merchant banking investments. Specifically, the rule prevents an FHC 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 FHC of all merchant banking investments exceeds:

· the lesser of 30 percent of the FHC's Tier 1 capital or $6 billion; or

· the lesser of 20 percent of the FHC's Tier 1 capital or $4 billion excluding investments made by the FHC in private equity funds.

An FHC may invest a greater amount only with prior approval from the Board.

ABASA strongly objects to the aggregate investment limits. The limits are neither supported by the plain language of the Act nor its legislative history. Erecting yet another barrier to an FHC's ability to engage in merchant banking activities ignores congressional intent that FHC's be able to participate in this important activity to the same extent and on the same basis that non-bank affiliated firms engage in the same activities.

Concerns about excess concentrations of capital for merchant banking activities without appropriate systems for monitoring and managing the associated risks, and concerns about failure to reserve sufficient capital against these activities, caused the Board and Treasury to propose aggregate investment limits. These types of concerns are not new to depository institutions or their regulators. Nor are these concerns limited to merchant banking activities. Banking regulators generally have addressed these issues through the supervisory process, not through the broad brush approach suggested here. No rationale has been offered to justify taking this new approach and, ABASA submits, none can be made. To the extent that these types of concerns exist, they should be addressed through the supervisory process.

Aggregate investment limits are an inappropriate regulatory tool for addressing concerns about excess concentrations, as they penalize those FHCs that have an established merchant banking business and can presumably more easily acquire new business that, under the proposed rule, would be subject to the aggregate investment limits. Yet these are the very firms - seasoned and mature - that we should want to engage in new merchant banking activities.

Moreover, we note that fixed dollar limits as opposed to percentage limits make no sense in today's consolidating markets. We understand, however, our concerns may be short-lived as the aggregate investment limits will be eliminated once the board has addressed capital rules applicable to merchant banking.

C. PRIVATE EQUITY FUNDS.

ABASA strongly objects to the unnecessary "look-through" restrictions placed on portfolio investments made by "private equity funds" in which an FHC makes a merchant banking investment. We believe these restrictions will needlessly deter FHCs from investing in private equity funds, a result that we believe is fundamentally at odds with the interim rule's intent.

The rule expressly recognizes that investments made by a private equity fund in which an FHC is merely a minority investor (no more than 25 percent) should be subject to fewer regulatory restrictions than investments made directly by an FHC. The rule makes this distinction because such private equity fund investments inherently raise fewer regulatory concerns. Proportionally less of the FHC's own capital is at risk. The majority participation by unaffiliated investors imposes significant market discipline on investment decisions. Their participation also helps ensure that funds are invested for bona fide investment purposes, rather than being used as a means for an FHC to engage in prohibited commercial activities through the merchant banking authority. Finally, the 25 percent limit establishes a strong presumption that the FHC's minority position will prevent it from exercising meaningful "control" over portfolio companies in which the fund invests, further reinforcing the banking/commerce separation.

For all of these reasons, the interim rule expressly - and appropriately - imposes fewer restrictions on portfolio investments made by a private equity fund in which the FHC invests than on portfolio investments made directly by an FHC, e.g., an FHC may hold a greater amount of investments in private equity funds than it may hold directly in portfolio companies.

In a number of other instances, however, the rule needlessly imposes the same burdensome restrictions on portfolio investments made by a private equity fund in which the FHC invests as it applies to portfolio investments made directly by the FHC - so-called "look through" restrictions. For example, when an FHC makes an investment in a private equity fund, no matter how small or passive, the rule's "routine management" and holding period restrictions apply not merely to the FHC's investment in the fund, but also "look through" to the portfolio investments made by the fund. That is, neither the FHC nor the fund may engage in any activity that would constitute "routine management or operation" of a portfolio company in which the fund has made an investment, and each of the fund's portfolio investments is subject to holding period limits.⁽⁷⁾

Similarly, where the FHC's investment in the private equity fund is deemed to be "non-passive" - even though it may never exceed 25 percent of the fund's equity - additional "look-through" restrictions are imposed. Again, these restrictions apply not just to the fund in which the FHC invests, but also to the portfolio company in which the fund invests:

1. The FHC's banks may not cross market the products and services of any portfolio company in which the fund has made an investment exceeding 5 percent of the company's equity (and such a company may not cross market the banks' products and services).

2. Restrictions under Sections 23A and 23B of the Federal Reserve Act presumptively apply to transactions between the FHC's banks and any portfolio company that is more than 15 percent owned by the fund.⁽⁸⁾

3. The rule's requirement for internal controls applies to the fund's portfolio investments.

4. The FHC must file reports regarding each of the fund's portfolio investments that is held for more than eight years.

ABASA recognizes that it is appropriate to impose restrictions on an FHC's first-level investment in a private equity fund, just as it is appropriate to impose restrictions on its direct merchant banking investment in a portfolio company. But ABASA also strongly believes that it is both unnecessary and inappropriate for any restrictions to extend beyond the qualified private equity fund in which the FHC invests to the portfolio companies in which the fund itself invests. As described above, and as the rule partly recognizes, investments made by a fund in which an FHC makes minority investments simply does not raise the same banking-commerce regulatory concerns as an FHC's direct investment in a portfolio company. The fact that the FHC's interest in the fund is limited to a minority participation of less than 25 percent, and the corollary that unaffiliated, arms-length investors will hold the remaining 75 percent (at least), ensures that the fund may not be used as a vehicle for the FHC to operate a portfolio company as opposed to merely investing in it.

Put starkly, an FHC may make a proportionally small investment (say, 6 percent) in a private equity fund that is clearly dominated and controlled by the other 94 percent of investors. In this circumstance, as ABASA understands the rule, both the FHC and the fund are prohibited from engaging in any action that would violate the rule's broad restrictions on the "routine management or operation" of a portfolio company in which the fund has made an investment - even if the fund's investment were both small and non-controlling. Given the clear distance of the FHC from the management or operation of such a portfolio investment, there appears to be little justification for extending the routine management restrictions to the FHC, and no justification for extending such restrictions to the fund itself. Similarly, in such circumstances, we see no reason that the rule's holding period restrictions, even though slightly longer for private equity fund investments, should apply at all to such investments.

The rule does recognize that certain of the "look through restrictions" (i.e., the cross marketing, Sections 23A and 23B, and internal controls restrictions) should not apply where the FHC's investment in the private equity fund is "passive." ABASA believes that making this general type of distinction is clearly appropriate, but that the rule's "passivity" criterion for making the distinction is inappropriate. Using "passivity" as the touchstone will import into the merchant banking context the complex precedent that the Board has used in very different contexts, e.g., for purposes of determining whether a company's investment in a bank should make it a regulated bank holding company. Such precedent is needlessly restrictive in the very different circumstance of a merchant banking investment made through a private equity fund.

Indeed, ABASA believes that the very limitations that apply in the rule's definition of "private equity fund" ensure that the FHC will not be able to use an investment in such a fund to operate a portfolio company in violation of the continued separation of banking and commercial activities. Specifically, the rule already requires that the FHC's investment in the fund, including related parties, may not exceed 25 percent of the fund's equity. In addition, the fund may not become an operating company, must hold diversified investments, and must establish a plan for the resale of investments. And perhaps most importantly, the fund may not be formed or operated for the purpose of making investments that are inconsistent with the merchant banking statutory provision or for evading any of the rule's limitations.

Taken together, ABASA believes that these definitional restrictions impose sufficient distance between the FHC and actual control of a portfolio company. The resulting separation makes unnecessary all of the rule's "look through restrictions" on portfolio companies held by qualifying private equity funds in which an FHC invests. Accordingly, ABASA urges the elimination of the rule's distinction between permissible "passive" and permissible "nonpassive" investments in a private equity fund, and elimination of the application of "look through" restrictions to any portfolio company investment made by a private equity fund.

Indeed, ABASA believes that, even if an FHC's investment in a private equity fund were to exceed 25 percent, it should not trigger the look-through restrictions unless the FHC were also the general partner of the fund. Put another way, the type of "control" that warrants the look-through provisions does not exist unless the FHC is both a general partner and has a significant equity stake in the fund. ABASA urges that this change to the rule's definition of "private equity fund" be adopted as well.

Finally, ABASA believes that one other aspect of the private equity fund provision ought to be modified. The rule currently requires a private equity fund to have at least 10 investors other than the FHC. We believe that this number is both needlessly large and counterproductive. First, contrary to the rule's commentary there are, in fact, examples of private equity funds that include fewer than 11 investors. Second, there should actually be fewer regulatory concerns where there are fewer investors. That is, where the clear majority of a fund's ownership is controlled by fewer investors, rather than being dispersed, it is less likely that an FHC's minority investment could be used to "control" a portfolio company in which the fund had made an investment. For that reason, ABASA believes that no restriction is required on the number of investors that comprise the majority investment in the fund.

D. PERMISSIBLE INVESTMENTS.

The interim rule specifies that allowable merchant banking investments must be made in any company "engaged in any activity not authorized pursuant to section 4 of the Bank Holding Company Act." That is, the company in which the FHC invests must be engaged in an activity that is not financial-in-nature or incidental to a financial activity or otherwise permissible for an FHC.

ABASA submits that it is incorrect to exclude from allowable merchant banking investments, investments in companies engaged in activities that are "financial-in-nature." We believe that as used in the statute, the reference to "any activity not authorized pursuant to this section" is meant to be descriptive rather than restrictive. The language merely differentiates the authority to engage in strategic investments from the authority to make merchant banking investments. If the acquisition is considered by an FHC to be merchant banking, it will be subject to all the limitations and conditions imposed by the Act. If instead, it is strategic, it will not be subject to these same limitations and conditions. The intent of the FHC at the time the acquisition is made should control, not the characterization of the investment as either financial-in-nature or merchant banking.

Also, from a practical point of view, it is unworkable. For example, an FHC makes a noncontrolling investment directly in a portfolio company and that company does not engage in any activities that are deemed to be financial-in-nature. Later, management of the portfolio company acquires a firm that is engaged in financial-in-nature activities. Under the interpretation posited by the interim rule, the FHC would be in violation of the merchant banking authority.

Similarly, FHCs may make noncontrolling investments in companies that are currently engaged primarily in activities that are financial-in-nature. The FHC cannot control whether that company branches beyond "financial-in-nature." If the FHC were forced to make this investment as "financial-in-nature" rather than as merchant banking, the FHC would have to divest within two years.

Finally, the definition of what is financial-in-nature is not fixed. Rather, as the Congress intended, it is a flexible, open-ended term that is meant to allow the regulators to take into account, among other things, changes in the marketplace and in the technology for delivery of financial services. An interpretation that views financial-in-nature and merchant banking activities as two separate and distinct businesses is sure to pose interpretive issues as the financial services industry evolves in the future.

E. PROHIBITION ON ROUTINE MANAGEMENT.

The Act prohibits FHCs from routinely managing or operating a portfolio company except as may be necessary or required to obtain a reasonable return on the resale or disposition of the investment. The interim rule 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.⁽⁹⁾ The interim rule also provides that an FHC 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.⁽¹⁰⁾ Finally, the rule sets forth those limited circumstances when it is permissible for an FHC to routinely manage or operate a portfolio company, requires documentation of these interventions, and limits the duration of the involvement.

ABASA believes that no definition of routine management and operation is necessary and that wherever possible the issue should be handled through the supervisory process. If, however, the Board and Treasury determine to go forward and define routine management and operation, ABASA suggests the following revisions:

1. An absolute bar on interlocks at the officer and employee level should be avoided. In addition, FHCs should have the flexibility to hire individuals below the top five executive level. For example, a portfolio company may need individuals with expertise in marketing or finance. It would not be unusual for the investment banking firm to both identify the need for such an individual and suggest a likely candidate for the position. That candidate may either be an employee of the FHC or someone with whom the FHC has experience. Unfortunately, the absolute bar on interlocks and prohibition on hiring executives below the top five would deny the portfolio company the ability to tap into the resources of its FHC investor.

2. References to agent should be eliminated. The interlock prohibition on officers and employees extends to agents of the FHC. ABASA recommends eliminating those references, as they seem to suggest that all agency relationships would be problematic. Of particular concern would be the hiring of a turnaround specialist who might be deemed to be an agent of an FHC due to some prior engagement.

3. The rule should reference the ability to select a general partner. The narrative portion of the release references the Board's existing interpretations that consider selection of a general partner to be the equivalent of selecting the board of directors. While ABASA is supportive of this position, it would be helpful if the interim rule clarified the permissibility of selecting a general partner.

4. Negative covenants should never be considered routine management. The interim rule identifies a set of covenants between an FHC and a portfolio company that generally would not be considered routine management. ABASA suggests that negative covenants, particularly financial covenants, should never be deemed to constitute routine management or operation of a company.

5. The exception is too narrow, does not comport with the Act, and should be broadened. The Act permits routine management where it is "necessary or required to obtain a reasonable return on investment upon resale or disposition." The interim rule, however, imposes a much more stringent standard. It permits routine management "only when 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." In addition, the interim rule imposes a six-month time limitation on routine management, a time limitation that is nowhere mentioned in the Act. Anything over six months would require Board approval and the FHC to document each instance of its involvement in routinely managing or operating a portfolio company. The legislative language should be sufficient with bank regulators providing supervisory oversight.

F. INVESTMENT HOLDING PERIOD.

The interim 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 qualifying private equity funds for the term of the fund, up to 15 years under certain circumstances.

Specific investment holding periods are contrary to the clear statutory language permitting an FHC to hold merchant banking investments for a sufficient period of time to "enable the disposition thereof on a reasonable basis consistent with the financial viability of investing for appreciation and ultimate resale or disposition." This requirement, like the Act's other conditions, is intended to maintain the separation between banking and commerce.

ABASA urges that investment holding periods be handled, wherever possible, through the supervisory process rather than through specific rules. Any abuses associated with holding investments longer than permitted should be addressed not through burdensome and costly regulatory disincentives but through the supervisory process.

If, however, the Board and Treasury determine that holding periods are appropriate, we urge a uniform holding period of 15 years for all merchant banking investments, not just for private equity funds. It is our members' experience that direct portfolio company investments are sometimes held beyond 10 years. In addition, a uniform holding period for investments in portfolio companies and private equity funds will reduce some of the regulatory burdens associated with the interim rule.

Other burdens associated with the interim rule also should be reduced. For example, holding period measures should be performed across the portfolio, not on an individual investment basis. In addition, distributions from private equity funds and sales of investments to private equity funds in which an FHC has an interest appear to require tacking of holding periods, which is burdensome and costly. Again, attempts to circumvent the holding periods should be addressed through the supervisory process not through rules that require tracking dates of original acquisition of the investment.

Finally, many FHCs will be unable to comply with the requirement of giving one year's notice in order to hold the investment beyond the normal holding period. An FHC may very well intend to sell an investment within the requisite time period, but market conditions may prevent the transaction from going forward. Moreover, the ability to seek an extension on some notice shorter than a year is not likely to be abused by FHCs, considering the capital implications and other restrictions associated with getting such an extension.⁽¹¹⁾ Nor does the Board need one year to decide if an extension is appropriate.

G. CROSS-MARKETING.

The Act prohibits depository institutions controlled by an FHC from marketing or offering, directly or through any arrangement, any product or service of a company held under the proposed 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). In implementing this provision, the interim rule extends the prohibition well beyond what is required by the Act.

Specifically, various types of subsidiaries should not be subject to the cross-marketing prohibition. The prohibition does not extend to financial subsidiaries authorized under section 5136A of the Revised Statutes or section 46 of the Federal Deposit Insurance Act. It should similarly not be extended to any other depository institution subsidiary authorized under specific statutory authority such as SBICs or Edge Act firms.

H. SECTIONS 23A AND 23B.

The interim rule implements provisions of the Act establishing a rebuttable presumption of control for purposes of the restrictions contained in Sections 23A and 23B of the Federal Reserve Act on transactions between a depository institution and a portfolio company in which the FHC owns or controls 15 percent or more of the equity capital of the company. The interim rule provides that the presumption may be rebutted with the agreement of the Board.

ABASA urges the Board to include in the rule two specific situations in which the presumption under Sections 23A and 23B should be considered to be rebutted. The first situation would provide that the presumption of control can be rebutted by demonstrating that an unaffiliated investor or two or more unaffiliated investors acting in concert hold, own or control, directly or indirectly, a greater amount of shares, assets or ownership interests in a portfolio company than does the FHC. The second situation would rebut the presumption of control if the FHC's ownership level in the portfolio company, private equity fund or other investment vehicle was less than 25%, the FHC had no more than one director on the board of the company or fund, and there was no other evidence or indicia of control on the part of the FHC.

IV. CONCLUSION

For all of the foregoing reasons, ABASA strongly urges the Board and Treasury to limit its activities to effectuating Congressional intent and addressing the fundamental concerns raised herein.

Sincerely yours,

 

Beth L. Climo

 

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1. S. Rep. No. 106-44, 106^th Cong., 1^st Sess. at 9; House Rep. No. 106-74, 106^th Cong., 1^st Sess. at 123.

· a FHC selecting any or all of the directors of a portfolio company if:

· the portfolio company employs officers and employees responsible for the routine management and operation of the company, and

· the FHC does not routinely mange or operate the portfolio company as described above.

· covenants or other provisions regarding extraordinary events including:

· the acquisition or control of significant assets of other companies;

· significant changes to the business plan of the portfolio company;

· the redemption, authorization or issuance of any shares of capital stock, and

· the sale, merger, consolidation, spin-off, recapitalization, liquidation, dissolution, or sale or substantially all of the assets of the portfolio company or any of its significant subsidiaries.

· Serving as or having responsibilities of an officer, employee or agent of the portfolio company and, at the same time, serving as director, officer, employee or agent of the financial holding company;

· supervising any officer or employee of the portfolio company and, at the same time, servings as a director, officer, employee or agent of the FHC;

· any covenant or other contractual arrangement between the FHC 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, and

· participation in the day-to-day operations of the portfolio company or the management decisions made in the ordinary course of business of the portfolio company.