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l l★K

Federal Reserve Bank
of Dallas

May 5, 2000

DALLAS, TEXAS
75265-5906

Notice 2000-28
TO: The Chief Executive Officer of each
financial institution and others concerned
in the Eleventh Federal Reserve District
SUBJECT
Joint Interim Rule and
Request for Public Comment Regarding
Merchant Banking Investments
DETAILS
The Board of Governors of the Federal Reserve System and the Secretary of the
Treasury have jointly adopted on an interim basis a rule that will govern merchant banking
investments made by financial holding companies. The rule, which became effective March 17,
2000, implements provisions of the recently enacted Gramm-Leach-Bliley Act that permit
financial holding companies to make investments as part of a bona fide securities underwriting or
merchant or investment banking activity.
Also, the Board and the Treasury have requested public comment on the interim rule.
Comments must be received by May 22, 2000. Please address comments to Jennifer J. Johnson,
Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution
Avenue, N.W., Washington, DC 20551. Also, you may mail comments electronically to
regs.comments@federalreserve.gov. All comments should refer to Docket No. R-1065.
ATTACHMENT
A copy of the Board’s notice as it appears on pages 16460–79, Vol. 65, No. 60 of the
Federal Register dated March 28, 2000, is attached.
MORE INFORMATION
For more information, please contact Rob Jolley, Banking Supervision Department,
at (214) 922-6071. For additional copies of this Bank’s notice, contact the Public Affairs
Department at (214) 922-5254 or access District Notices on our web site at
http://www.dallasfed.org/banking/notices/index.html.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

Tuesday,
March 28, 2000

Part II

Federal Reserve
System
Department of the
Treasury
12 CFR Parts 225 and 1500
Bank Holding Companies and Change in
Bank Control; Interim Rule and Proposed
Rule

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16460

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

12 CFR Part 1500

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.

RIN 1505–AA78

FOR FURTHER INFORMATION CONTACT:

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

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.
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
regs.comments@federalreserve.gov) 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
financial.institutions@do.treas.gov).
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

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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

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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

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

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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

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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

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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,

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

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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.
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.
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
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.
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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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.
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
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).
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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financial activities without resorting to
merchant banking authority.
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

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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

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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 socalled 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

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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

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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

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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 1year 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 oneyear 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 crossmarketing, 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

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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 10year 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.

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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.

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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

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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.

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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 thirdparty 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

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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 noncontrolling 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

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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.

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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 crossmarketing 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

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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.
Neither the GLB Act nor the rule
applies these restrictions to crossmarketing 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 crossmarketing 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 crossmarketing 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
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.

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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

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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.

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16469

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
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
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 riskweighted and average consolidated assets.

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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

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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 deconsolidate 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

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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

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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.
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 riskbased 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
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.

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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

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16471

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

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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)

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17:28 Mar 27, 2000

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.

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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:
§ 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?

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Subpart J—Merchant Banking
Investments
§ 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,

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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 § 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 § 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 §§ 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:

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16473

(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.
§ 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

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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.

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(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.
§ 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

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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

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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;

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(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.
§ 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.
§ 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

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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

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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

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connection with an investment made
under this subpart if the financial
holding company has previously filed a
notice under § 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.
§ 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

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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

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

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(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 § 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:

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(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 § 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.
§ 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

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

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

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(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.
§ 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

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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

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

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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

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operate a portfolio company except as
permitted by this part.
§ 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.
§ 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.
§ 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

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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102