Banks and thrifts (and their holding companies) have long found Small Business Investment Companies (SBICs) to be an attractive vehicle to engage in venture capital activities that might otherwise be prohibited. While the Gramm-Leach-Bliley Act expands the authority of bank holding companies to engage in venture capital activities, there are still a number of compelling reasons that SBICs will continue to be attractive.
Banks and SBICs
Under current law, venture capital financing by banks, thrifts and their holding companies is severely constrained. For example, national banks have authority to take "equity kickers" (including in the form of warrants), but can never take actual ownership of an equity position in a company that is engaged in activities outside of the "business of banking." Bank holding companies had somewhat broader authority, but generally could not take positions that were in excess of 5 percent of any class of voting shares, or that represented more than 25 percent of total capital. Savings associations arguably have broader authority in this area through service corporation subsidiaries, but this has not been fully tested.
As a result of these limitations, SBICs have been an attractive investment for banks and bank holding companies. SBICs are licensed as such by the Small Business Administration (SBA) under the Small Business Investment Company Act (SBIC Act). An SBIC provides venture capital financing, including equity investments in and loans to companies that are eligible pursuant to the SBIC Act. Being licensed as an SBIC entitles the firm to participate in certain federal government funding programs administered by the SBA.
Pursuant to express authority in the SBIC Act, national banks are authorized to invest up to 5 percent of their capital and surplus in one or more SBICs. This authority also extends to bank holding companies, and many states have adopted parallel authorizations for state-chartered banks and thrifts. In addition, the Office of Thrift supervision has recently given strong indications that SBIC investments would be permissible service corporation investments for a federal thrift.
By investing in an SBIC, a bank, thrift or holding company can indirectly engage in a wide range of venture capital financing, including the taking of equity positions, without regard to the limitations described above.
In addition, such SBIC investments have been made even more attractive by interpretations under the Community Reinvestment Act, establishing that such investments will be presumed to meet the "community development" standard for qualified investments under the CRA regulations.
The Provisions of Gramm-Leach-Bliley
A principal feature of the Gramm-Leach-Bliley Act is the allowance of banking, securities and insurance activities within the same holding company system, effective 120 days after enactment (i.e., on March 11, 2000). This is achieved by creating a new kind of bank holding company, called a "financial holding company," with authority to engage not only in activities that are "closely related to banking" but more broadly in any activity that the Fed determines to be "financial in nature or incidental to such financial activity" or that the Fed determines is "complementary to financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally."
In defining certain activities that are "financial in nature," the Act sets out specific conditions for merchant banking or venture capital activities. Generally, a financial holding company is authorized to take, through a securities affiliate (1)(but not through a depository institution or subsidiary of a depository institution), equity positions in any company, provided:
- the position is part of a bona fide underwriting or merchant or investment banking activity, including investment activities engaged in for the purpose of appreciation and ultimate resale or disposition of the investment.
- the position is held for a period of time to enable the sale or disposition thereof on a reasonable basis consistent with the financial viability of the activities of the underwriting or merchant or investment banking activity being engaged in and
- during the period such position is held, the bank holding company does not routinely manage or operate such company or entity except as may be necessary to obtain a reasonable return on investment upon resale or disposition.
Pursuant to this authority, bank holding companies will be able to engage in broad venture capital activities without the use of an SBIC. Also, while the broad authority for unitary thrift holding companies to engage in virtually any activity is terminated by the Gramm-Leach-Bliley Act, savings association holding companies that meet the standards for treatment as a unitary thrift holding company will have the same powers as financial holding companies, including in the area of venture capital activities. (There is some question whether these powers will also extend to thrift holding companies that do not meet the standards of a unitary thrift holding company.)
Notwithstanding these new merchant banking powers, there are a number of reasons that SBICs will continue to be an important tool for banks, thrifts and their holding companies.
Continuing Benefits of SBICs
Ability to Invest Through the Depository Institution or Its Subsidiaries
The broad venture capital authorization for financial holding companies is expressly precluded for depository institutions and their subsidiaries. This limitation is also reflected in the provisions of the Act relating to expanded powers for national bank subsidiaries - the permitted activities for the newly authorized "financial subsidiaries" of national banks expressly exclude the venture capital powers described above for at least five years.(2)
The Act, however, does not alter the express authority under the SBIA for national or state banks to invest in SBICs, nor should it affect the authority of the OTS to approve investments in SBICs through service corporations, or state authorizations for bank and thrift investments in SBICs. Accordingly, SBICs continue to provide a means to engage in venture capital activities through a depository institution or its subsidiary.
Freedom in Lending to Portfolio Companies
Sections 23A and 23B of the Federal Reserve Act impose severe restrictions on lending by a depository institutions to an affiliate. If venture capital activities are engaged in through a holding company subsidiary, that subsidiary is an affiliate, and if the interest in a portfolio company results in control, then the portfolio company also is an affiliate.(3) If a portfolio company is an affiliate, loans to the portfolio company by the affiliated depository institution would be generally precluded. Exacerbating this problem is a provision of the Gramm-Leach-Bliley Act that creates a new presumption that any portfolio investment pursuant to the above-described venture capital authority that exceeds 15 percent of the total equity (whether voting or non-voting) of the portfolio company will be presumed to result in control for purposes of the restrictions of Sections 23A and 23B.
The restrictions of 23A and 23B generally do not apply to subsidiaries of the depository institution such as an SBIC and any of its portfolio companies (whether or not controlled). As a result, by using an SBIC housed in a subsidiary of the depository institution, there is much greater freedom to finance portfolio companies from the depository institution. In addition, some benefit may also be gained in this regard even where the SBIC investment is made by the holding company, since the new 15 percent rule by its terms only applies to investments made under the merchant banking authority given by the new Act.
Presumption of Qualification for CRA Credit
As noted above, the federal regulators have indicated that an SBIC will be presumed to meet the "community development" standard for qualified investments under the CRA regulations. While the regulators might be persuaded on a case-by-case basis that other venture capital activities meet this standard, there would be a burden of persuasion not present if an SBIC is used. Assuming the SBIC has the requisite geographic focus, an investment in an SBIC should count toward the quantitative assessment of an institution's qualified investments, no questions asked.
Absence of Conditions
The Gramm-Leach-Bliley Act imposes a number of conditions on financial holding companies that seek to take advantage of the expanded powers authorized under the Act, including the venture capital activities described above. Specifically, at all times that a financial holding company is engaged in such activities, all of its depository institution subsidiaries must be well managed and well capitalized. In addition, as a condition to commencing any new activity, all depository institutions subsidiaries must have at least a "satisfactory" CRA rating. These conditions would not apply to SBIC investments authorized under existing law.
Conclusions
While the Gramm-Leach-Bliley Act creates a world of opportunities for "financial holding companies," SBICs continue to offer some clear and compelling benefits and should continue to play an important role for banks, thrifts and their holding companies.
If you would like further information regarding SBIC opportunities for your institution, please feel free to contact us.
Also see our other Updates on the Gramm-Leach-Bliley Act:
- The Gramm-Leach-Bliley Act: What's In It for the Insurance Industry
- The Gramm-Leach-Bliley Act: What's In It for the Investment Management Industry
- The Gramm-Leach-Bliley Act: New Privacy Provisions Become Law
- The Gramm-Leach-Bliley Act: What's In It for Banks and Thrifts
ENDNOTES
1. The Act does not clearly define the requirement that investments be made through "a securities affiliate or affiliate thereof." Clearly, the test would be met by housing the activity in what used to be the bank holding company's Section 20 subsidiary, along with other SEC-regulated securities activities. Arguably, a subsidiary engaged solely in this sort of merchant banking activity is itself a "securities affiliate" meeting this requirement. The Act also allows for certain merchant banking activities through insurance companies and investment advisers to insurance companies.
2. The Act provides for the possibility of a joint rule by the Fed and the OCC allowing for such merchant banking activities in financial subsidiaries of national banks after five years.
3.By statute, ownership of 25 percent of any class of the voting stock, or control over the election of a majority of directors, is deemed to constitute control. The Fed generally has taken the view in this and other contexts that if a holding company controls a subsidiary, then the investments of the subsidiary would be fully attributed to the parent holding company. Thus, if a holding company holds 50 percent of a venture capital company, and the venture capital company acquires 25 percent of the voting stock of a portfolio company, the portfolio company would be an affiliate under Sections 23A and 23B (and the holding company would have to have the authority to hold such an interest in the portfolio company). If the holding company has less than a controlling interest in the subsidiary (if it can still be called that), then the Fed has indicated that the parent holding company could be considered to have a proportionate share of any investments of that subsidiary - e.g., if a holding company holds 10 percent of a venture capital enterprise, which has a portfolio investment representing 75 percent of the voting stock of the portfolio company, then the holding company could be deemed to control 7.5 percent of the portfolio company.