Legislation recently introduced by Rep. Richard Baker, R-La., the Entrepreneurial Investment Act, is an unwise piece of legislation for banks and the banking industry.
The bill would allow bank holding companies with assets of less than $1 billion to make equity investments in their corporate borrowers. It proposes allowing holding companies to acquire up to one-quarter of the voting shares of these corporate borrowers.
Politically, such legislation may be of some value, but for financial institutions it is likely to be a mine field.
Permitting holding companies to invest in the equity of their banks' corporate borrowers would create conflicts of interest between the holding company and its bank subsidiary. The interests of creditors and shareholders are in some aspects legitimately different, and this legislation could place financial institutions in a position of playing chess against themselves.
Placing the bank and its holding company in the position of creditor and owner, respectively, of the same corporation could put the holding company in a position of attempting to serve two masters, each with a different interest.
This scenario would be further complicated should a financial institution find it necessary to put one of its board members or officers on the board of the corporation in which the financial institution has an equity investment. In such a situation the bank officer or director may find a direct conflict regarding his fiduciary duty to his own shareholders and those to the shareholders of the borrowing customer.
Occasions would also arise where pressure would build on a bank to increase its lending, or on a holding company to bolster its capital investment in a troubled corporate borrower, in order to strengthen the position of the other party.
One of my last assignments prior to leaving the Federal Deposit Insurance Corp. was assisting in a study for Congress regarding insider transactions and the degree of abuse in them. As a result of the study, Congress saw fit to pass the Financial Institutions Regulatory Act; the implementing regulation has become known as Reg O.
While Reg O could use some touching up here and there, I do believe it is a reasonable regulation. It was designed to prohibit insiders, who are defined as directors, executive officers, principal shareholders, and their related interests, from taking advantage of their inside position in any manner that would result in the insider's receiving preferential lending treatment.
Clearly, Mr. Baker's proposed law would frustrate the theories underpinning Reg O as well as the common-law duties of loyalty and care that directors owe their organizations.
I believe the majority of holding companies that undertake to make such investments in their corporate customers will do so prudently. I am also convinced that there will be some who will see this as an opportunity to stretch the bounds of reasonableness to make equity investments in organizations that they would normally not bank. Those bankers who are not interested may be forced to defend themselves for declining these unwise investments.
Looking down the road a few years, I can envision that such legislation could create an environment conducive to a new wave of litigation involving financial institutions that find themselves in the dicey position of being lenders and equity investors in the same organization.
The relationship between a financial institution and its corporate borrowers should remain a healthy debtor/creditor relationship. Equity investments in such companies should be left to those who get paid to take these kinds of risks.
Mr. Freibert is president of Louisville, Ky.-based Bank Professional Services, a consulting company.