The Board of Governor's new Regulation W, Transactions Between Member Banks and Their Affiliates (codified at 12 CFR Part 223), became effective on April 1, 2003.1 Regulation W implements sections 23A and 23B of the Federal Reserve Act and provides a comprehensive reference tool for complying with the statute. Sections 23A and 23B and Regulation W limit the risks to a bank from transactions between the bank and its affiliates and limit the ability of a bank to transfer to its affiliates the subsidy arising from the bank's access to the Federal safety net (i.e., lower cost insured deposits, the payments system, and the discount window).
This article focuses on a narrow part of Regulation W, but one that often raises questions: the application of Regulation W to holding company internal corporate reorganization transactions.
Sections 23A and B and Regulation W achieve their purposes by imposing quantitative and qualitative limits on the ability of a bank to make loans to, or enter into certain other transactions with, an affiliate. Generally, section 23A prohibits a bank from engaging in so-called "covered transactions" with an affiliate unless the bank limits the aggregate amount of such transactions to that particular affiliate to 10 percent of the bank's capital stock and surplus and collateralizes the transactions. Also, section 23A restricts the aggregate amount of all covered transactions between a bank and its affiliates to 20 percent of the bank's capital stock and surplus. Section 23B requires that transactions between a bank and its affiliates be conducted on "arms length" or market terms.
From time to time, bank holding companies move various operations from beneath the bank to the bank holding company or from the bank holding company to beneath the bank. Typical transactions involve the transfer within the holding company structure of trust and related investment advisory and administrative activities or mortgage banking operations, generally for strategic or funding reasons. Regulation W establishes some new limits for these transactions and provides several new exemptions for some of the most common transactions structured as internal corporate reorganizations.
Types of Merger and Acquisition
Banks and their Affiliates
Regulation W includes within the definition of a covered transaction a member bank's purchase of assets from an affiliate and a member bank's purchase of, or investment in, securities issued by an affiliate (see 12 CFR 223.22 and 223.31). In the past, the Board applied these provisions to transactions where a member bank either directly or indirectly acquired an affiliate. The Supplementary Information (SI) issued for Regulation W on November 27, 2002 provides useful guidance on merger and acquisition transactions between a member bank and an affiliate. 2
The SI to Regulation W notes at Subpart D that, generally, a bank uses one of three methods to acquire an affiliate. The first is a purchase of assets and assumption of liabilities by the bank. The Board treats such a transaction as a purchase of assets under section 23A, and the covered transaction amount is equal to the amount of the separate consideration paid by the member bank for the affiliate's assets (if any) plus the amount of the liabilities assumed by the bank in the transaction.
In the second method, the bank acquires an affiliate by merger. Mergers between state chartered banks and their affiliates are infrequent because many state banking codes only permit bank-to-bank mergers. National banks received authority to merge with nonbank affiliates in 2000 and are beginning to exercise that authority.3 This type of transaction has, in the past, also been treated as a purchase of assets since the transaction is effectively the equivalent of the purchase of assets and assumption of liabilities transaction described above. Again, the covered transaction amount is equal to the amount of the separate consideration paid by the bank for the affiliate's assets (if any) plus the amount of the liabilities assumed by the bank in the transaction.
The third method involves the contribution or sale of a controlling block of the shares of an affiliate to a subsidiary bank, thereby making the contributed company a subsidiary of the bank and no longer an affiliate of the bank for section 23A purposes. Prior to Regulation W, the Board had treated these types of stock sales or contributions as purchases of assets covered by section 23A if the member bank paid consideration for the shares or if the affiliate whose shares were contributed to the member bank had liabilities to any affiliate of the bank. The SI to Regulation W notes that the Board had adopted this approach because these types of internal reorganizations were frequently driven by a desire to solve funding problems at the transferred affiliate through the bank's resources. Following many such reorganizations, the transferred affiliate's liabilities to the holding company were paid down by bank funds.
Regulation W does not change the treatment of either method one (purchase of assets/assumption of liabilities) or method two (statutory merger) but does introduce different treatment for the third type of transaction. Under Regulation W, the acquisition by a bank of securities issued by an affiliate company is treated as a purchase of assets from an affiliate if all of the following criteria are met (see 12 CFR 223.31(a)).
The regulation further provides that these transactions must be valued for purposes of the covered transaction quantitative limits initially at the greater of the following two formulae (see 12 CFR 223.31(b)).
Regulation W now places in the valuation calculation "total liabilities," including liabilities to third parties, not just liabilities to affiliates.
In effect, Regulation W requires member banks to treat share donations and purchases in the same fashion as if the bank had purchased the assets of the transferred company at a purchase price equal to the liabilities of the transferred company plus any separate consideration paid by the bank for the shares.
The ongoing valuation for this type of transaction may be reduced after the initial transfer to reflect certain post restructuring events: 4
If the newly acquired subsidiary engages in lending activities and the loans are transferred as part of the transaction, the quantitative amount of the covered transaction is reduced as the loans are repaid (see 12 CFR 223.22 (c) (1)).
The rule only imposes asset purchase treatment on affiliate share transfers where the company whose shares are being transferred to the bank was an affiliate before the transfer. The regulation generally exempts qualifying "step transactions" that involve purchases by bank holding companies of companies from third parties when the purchased entity in turn becomes an affiliate and is then, within one business day (or such longer period, up to three months, as may be permitted by the bank's appropriate Federal banking regulator), downstreamed to become a subsidiary of the bank. These transactions are subject to several other restrictions including the safety and soundness requirement and the market terms requirement of section 23B (see 12 CFR 223.31(d) and (e)).
Reg W Exemption for Qualifying Internal Reorganizations
Internal corporate reorganization transactions, while being covered transactions under section 23A, may be exempted by Regulation W from the quantitative 10 percent per affiliate and 20 percent aggregate limits and collateral requirements of section 23A. 12 CFR 223.41(d) provides for such an exemption if all five of the following conditions are met.
Other Types of Affiliate Transfers
There are other types of affiliate transfers in internal corporate reorganizations that require analysis under Regulation W. Among these are the transfer of a subsidiary of a bank to the holding company and transfers of operations between banks.
A transfer of a subsidiary from a bank to the bank's holding company is not a covered transaction under section 23A but is subject to section 23B's market terms requirement. Also, the purchase of loans between affiliated banks, while a covered transaction, is exempt from both the quantitative and collateral requirements of Regulation W (see 12 CFR 223.41(b) and (c)). The transfer or purchase by a bank of part of an affiliate is treated as the purchase of, or an investment in, shares issued by an affiliate (see 12 CFR 223.23). Finally, the purchase of an affiliate that becomes a financial subsidiary of a bank is governed by special valuation rules because, in part, the financial subsidiary is treated as an affiliate of the bank.
Regulation W's exemption for qualifying reorganizations will provide a welcome safe harbor for many of the most common internal reorganization transactions. However, the regulation requires precise analysis when considering holding company internal corporate reorganization transactions.
Depository institutions should direct any questions on the application of sections 23A and 23B and Regulation W to their primary federal banking regulator. Institutions supervised by the Federal Reserve Bank of Philadelphia should direct questions to the examiner-in-charge of an on-going supervisory event, the institution's central point of contact at the Reserve Bank, or an officer or manager in Community, Regional, and Global Supervision or Regulatory Applications.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.