By Scott Petepiece and David L. Portilla
Scott Petepiece is the head of Shearman & Sterling LLP's New York Mergers & Acquisitions Group. He represents U.S. and multinational corporations, banks and other financial institutions in acquisitions and sales of public and private companies and in joint ventures, minority investments and consortium transactions. David L. Portilla is counsel in the global Financial Institutions Advisory & Financial Regulatory Group of Shearman & Sterling LLP. Mr. Portilla's practice focuses on advising international and domestic banks and financial institutions on bank and broker-dealer regulatory and transactional matters.
In December 2012, the Federal Reserve proposed new enhanced prudential standards for foreign banking organizations (“FBOs”).1 An FBO is a foreign bank that has a banking presence in the United States either because it operates a branch, agency or commercial lending company subsidiary or because it controls a U.S. bank. The standards include capital and liquidity requirements, single counterparty credit exposure limits, stress testing requirements, risk management standards, early remediation standards, and debt-to-equity limits. These are all important requirements and undoubtedly will have a meaningful impact on FBOs. However, the Federal Reserve's proposal to require certain FBOs to establish an intermediate holding company (“IHC”) for U.S. operations (other than branches and agencies) might turn out to be the most significant aspect of the proposed enhanced prudential standards. This article focuses on the potential for the IHC requirement to lead to internal restructuring and asset dispositions, and some of the key issues that may arise as a result of this requirement.
The requirement to establish an IHC applies to FBOs with U.S. assets of $10 billion or more, excluding branches and agencies. 2 For those FBOs that are required to establish an IHC, the proposed enhanced prudential standards, including U.S. risk-based capital requirements and leverage standards, will apply at the IHC level.3
Applying U.S. risk-based capital requirements and leverage standards at the IHC level could require certain firms to significantly increase their capital levels or reduce their assets. In particular, because a leverage requirement is not risk sensitive, it will disproportionately impact those FBOs whose U.S. operations consist mostly of a broker-dealer, as broker-dealers may hold a significant amount of low risk-weighted balance sheet assets, such as Treasuries, as part of a repo book.
FBOs will face a number of issues as they consider how to restructure their operations in response to the IHC requirement.
As a preliminary matter, if an FBO already has an IHC for its U.S. operations, the FBO will still need to analyze the entities and operations that are held under this IHC. It is possible that there are some entities or operations that do not need to be under the IHC and can be moved to other parts of the FBO's organization. For example, some non-U.S. subsidiaries may be held through a chain of ownership that includes U.S. subsidiaries. In some cases, non-U.S. subsidiaries might not be relevant to U.S. operations, and could be moved to a non-U.S. chain of ownership in order to avoid having to hold capital against such non-U.S. operations. However, as discussed in more detail below, before undertaking any such reorganization, the FBO should analyze the implications of doing so. This analysis should include a change of control review, a review of important customer and other contracts, and a review of the potential tax and other regulatory implications of a reorganization.
Any FBO that does not currently have an IHC should analyze the operations it currently conducts in the United States, and consider whether it is possible to conduct any of these operations outside of the U.S. For example, it is possible that some securities activities could be conducted from outside the United States under the Securities and Exchange Commission's Rule 15a-6. If an FBO is able to conduct activities through non-U.S. entities, the FBO potentially could avoid having to hold capital at the U.S. IHC level against these activities. On the other hand, moving activities outside of the United States could trigger the need to update customer agreements and other documentation. Thus, the FBO should weigh the benefit of moving the activities outside of the United States opposite the cost of doing so.
In addition, FBOs should conduct a global legal entity review to determine which entities must be placed under the IHC, and also should conduct a change of control review for each entity that is identified. This exercise is tantamount to the comprehensive due diligence that is performed in advance of significant merger and acquisition transactions. Moreover, because the proposed rule defines “subsidiaries” using the Bank Holding Company Act definition of the term “control”, entities that are not wholly owned, such as joint ventures and minority interests, may need to be moved under the IHC. Under this standard, an FBO would be required to transfer its interest in a joint venture or other entity if the FBO: (i) directly or indirectly owns, controls, or has the power to vote 25 percent or more of any class of voting securities of the joint venture or entity; (ii) controls in any manner the election of a majority of the directors or trustees of the joint venture or entity; or (iii) directly or indirectly exercises a controlling influence over the management or policies of the joint venture or entity. 4
The FBO Proposal raises a number of issues. For example, the proposal seems to assume that any interest in a joint venture is held directly by the FBO and could be transferred by the FBO to an IHC without significant complications. However, a U.S. entity could be held by two FBOs indirectly through a non-U.S. joint venture. A reading of the plain language of the proposal would seem to require either the ownership of the non-U.S. joint venture to be transferred to a single IHC, or for the two FBOs to cause the non-U.S. joint venture to transfer the FBOs' respective interests in the U.S. entity to their respective IHCs. This outcome, however, seems illogical and would be at odds with the proposal's objective of facilitating an FBO's ability to oversee its U.S. operations, and may present other complications.5 Thus, as discussed below, FBOs in this situation should consider whether to seek an exception from the IHC requirement.
In terms of timing, any FBO that meets the asset thresholds as of July 1, 2014 would be required to establish an IHC by July 1, 2015, unless that date is extended in writing by the Federal Reserve. 6 In addition, the proposed rule provides the Federal Reserve with authority to permit alternative U.S. organizational structures “in exceptional circumstances.”7 A request for an exception from the IHC requirement would need to be submitted to the Federal Reserve at least 180 days prior to the date that the relevant FBO is required to establish an IHC.8 As examples, the FBO Proposal notes that alternative structures may be permitted in cases where an FBO controls multiple lower-tier FBOs that have separate U.S. operations, or where an alternative structure is warranted based on the FBO's activities, scope of operations, structure or other similar considerations. However, the standards that the Federal Reserve would apply in evaluating requests for exceptions are not clear, and the Federal Reserve has not indicated whether it is likely to grant any exceptions.
Given the potentially significant impact of the IHC requirement, it would be prudent for any FBO that meets the $10 billion asset threshold to commence a global legal entity and change of control review, a review of customer agreements and other important contracts, as well as a related regulatory and tax analysis. Once this review is complete, the FBO will have a better basis on which to evaluate whether asset dispositions or other solutions are the most efficient route to address the new IHC requirement and the attendant capital, liquidity and other standards that are a part of the FBO Proposal.
1 Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies, 77 Fed. Reg. 76,629 (Dec. 28, 2012) (“FBO Proposal”). The FBO Proposal would be codified as 12 C.F.R. pt. 252, Regulation YY of the Federal Reserve.
2 12 C.F.R. §252.201(a). The FBO Proposal includes a methodology for calculating these asset thresholds.
3See FBO Proposal at 76,637.
4Id. at 76,638 (noting that the definition of subsidiary includes interests in JVs that meet the control definition described above).
5Id. at 76,637.
6 12 C.F.R. §252.200(b).
7 FBO Proposal at 76,638.
8 12 C.F.R. §252.202(b).
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