The Federal Reserve's Revisions to Regulation K

The Federal Reserve Board's most recent revisions to Regulation K took effect May 24.

The International Banking Act requires the Fed to review and revise its regulations governing Edge corporations at least once every five years. The Edge Act, passed in 1919, allows banks to establish offices outside their home states purely for the purpose of assisting in foreign trade transactions.

In August 1990 the Fed proposed broad revisions of Regulation K, including provisions that regulate both the foreign activities of U.S. banking organizations and the U.S. activities of foreign banking organizations.

Not surprisingly, the final revisions represent a rather conservative approach to the easing of some regulatory burdens and restrictions that confront domestic and foreign banking organizations. The revisions also impose certain additional burdens, including a requirement for Edge Act corporations to strengthen their capital.

Securities Activities Abroad

The Fed has raised the dollar limitations applicable to equity underwriting and dealing activities abroad. Under the revised Regulation K, a U.S. banking organization may underwrite equity securities abroad, provided that its commitments to any one issuer do not in the aggregate exceed the lesser of $60 million or 25% of the relevant investor's Tier 1 capital.

Under Regulation K, investors include member banks, bank holding companies, and Edge Act and Agreement corporations. To determine the extent of its underwriting commitment, a banking organization must include commitments of all affiliated companies, except Section 20 subsidiaries.

With the Fed's approval, a U.S. banking organization may underwrite issues in excess of the $60 million limit, provided that:

* The excess underwriting level approved by the Fed is fully deducted from the capital of the relevant bank holding company and from the capital of the relevant bank where the securities activities are conducted by a bank subsidiary.

* In the Fed's judgment, the applicable bank holding company or bank remains "strongly capitalized" after the excess amount is deducted from their regulatory capital.

As in the past, these limitations may also be exceeded if the underwriter is covered by binding commitments of subunderwriters or other purchasers.

A U.S. banking organization may underwrite up to 100% of an issuer's equity securities. However, the subsidiary must reduce its holdings to permissible dealing limits within 90 days after the issuer receives the net proceeds of the underwriting.

A foreign subsidiary of a United States banking organization may trade or deal in equity securities, provided that such trading or dealing activity in respect of any one issuer does not exceed the lesser of $30 million or 10% of the investor's Tier 1 capital.

To reduce its exposure to equity positions, a banking organization may establish netting techniques subject to Fed approval. However, the Fed has imposed a "haircut" on the use of netting techniques, such that the risk exposure associated with an equity position may not be reduced by more than 75% through hedging.

A foreign subsidiary of an Edge Act corporation or bank holding company may deal in equity securities of a U.S. issuer, provided that the securities are sold to or purchased from foreign persons. A foreign subsidiary that deals in securities of a U.S. issuer cannot acquire more than 5% of the issuer's voting shares or more than 24.9% of the issuer's total equity.

Prior Fed approval must be obtained in order to take advantage of Regulation K's expanded underwriting and dealing authority. In particular, the Fed will review whether the internal procedures and capital conditions are sufficient to support expanded underwriting and dealing activities.

Portfolio Investment Authority

Under the revised Regulation K, U.S. banking organizations still may not acquire more than 19.9% of the voting shares of a nonfinancial foreign company. However, banking organizations are now subject to a 40% limitation on total "equity" investments in nonfinancial companies, including both voting and nonvoting shares. If a banking organization or an affiliate invests in the equity of a foreign company, the banking organization can extend credit to that company only on arm's-length terms.

Under the prior Regulation K, a U.S. banking organization could not invest more than 100% of its capital and surplus in foreign companies engaged in impermissible activities. Edge Act corporations and member banks remain subject to the 100% limit. However, a bank holding company may no longer invest more than 25% of its capital and surplus in foreign companies engaged in such activities.

Investment Authority

Under the prior Regulation K, a U.S. banking organization could invest the lesser of $15 million or 5% of its capital and surplus in any permissible activities abroad without prior notice to the Fed. The Fed has revised Regulation K to increase these dollar limitations applicable to the general consent investment procedures.

Subject to certain limitations, a U.S. banking organization may now invest the lesser of $25 million or 5% of its Tier 1 capital in permissible foreign activities without prior Fed approval or prior notice.

The Fed has revised Regulation K to increase the dollar limits applicable to debt-for-equity investments permissible without prior Fed notice or approval.

A bank holding company now may invest, without prior Fed notice or approval, the greater of $25 million or 1% of Tier 1 capital in debt-for-equity swaps.

Divestiture Requirements

In addition, the Fed has confirmed that bank holding companies may engage in otherwise permissible debt-for-equity swaps outside the scope of a formal government program.

Under Regulation K, a bank holding company has been required to divest permissible equity investments in foreign companies after a period of years. Specifically, a bank holding company has been required to divest equity investments within two years of the date the debtor country permits repatriation, subject to a maximum overall holding period of 15 years.

The Fed has modified this requirement in recognition of the fact that some debtor countries do not restrict repatriation of equity investments because they have no formal debt-for-equity program. The revised regulation requires a bank holding company to divest its equity investment in a foreign company within 10 years of acquisition, subject to extensions that may not exceed five years.

Under the prior version of Regulation K, a bank holding company had to promptly divest an equity investment in a foreign company that engaged in impermissible activities in the United States.

A bank holding company may now retain, for the normal holding period, investments in a foreign company engaged in impermissible activities, provided that the foreign company derives no more than 10% of its consolidated assets or revenues from U.S. activities. However, the exception excludes foreign companies engaged in U.S. financial activities that require prior Fed approval.

Edge Act Capital and Activities

Heretofore, Edge Act corporations have been required to verify that banking transactions they conduct in the United States have an international character or purpose. As an exception to this rule, Edge Act corporations have been permitted to take deposits from foreign persons and governments and to provide general banking services to companies ("qualifying business entities") that engage predominantly in international activities.

The Fed decided to permit Edge Act corporations to provide full domestic banking and lending services to foreign persons - including foreign governments and agencies, offices or establishments located, and individuals residing outside the United States.

Edge Act corporations engaged in banking are now subject to increased capital requirements. As of Dec. 31, 1992, these corporations must maintain a 10% risk-based capital level, with at least half of that amount comprised of Tier 1 capital. However, an Edge Act corporation may maintain all of its Tier 2 capital in the form of subordinated debt.

An Edge Act corporation is now required to include in its bylaws a provision authorizing the Fed to call an emergency meeting of the corporation's shareholders. If a shareholder or group of shareholders holds 25% or more of the Edge Act corporation's shares and fails to attend the meeting, it may be barred from further participation in the corporation's affairs.

Added Permissible Activities

U.S. banking organizations have been permitted to engage in a number of specific foreign activities without prior Fed approval. The revised Regulation K expands this list of permissible foreign activities to include life insurance underwriting, futures commission merchant activities, and currency and interest rate swap transactions.

The prior Regulation K permitted U.S. banking organizations to underwrite credit life, accident, and health insurance abroad. While the revised Regulation K retains current restrictions on the foreign insurance activities of member banks and Edge Act corporations, a bank holding company may now underwrite life, annuity, and pension fund-related insurance through a foreign insurance subsidiary. However, the bank holding company must deduct from its regulatory capital, investments in - and unsecured extensions of credit to - the foreign insurance subsidiary.

Futures Commission Merchants

The revised Regulation K codifies these prior Fed approvals. U.S. banking organizations are now authorized to conduct futures commission merchant activities on any foreign exchange previously approved by the Fed. However, a U.S. banking organization must obtain approval to conduct these activities on any new exchange.

To expedite the review process, the Fed has authorized Federal Reserve Banks to review applications involving previously approved exchanges. However, the Fed must review any application involving a new exchange.

U.S. banking organizations may engage in swap activities abroad, including commodity swap transactions, to the same extent that state member banks are permitted to conduct swap transactions in the United States. However, Edge Act corporations may engage in commodity swap activities abroad only if the activity involves a contract with an option for cash settlement.

Under Section 2(h) of the Bank Holding Company Act, the Fed may exempt the activities of certain foreign banking organizations from the nonbanking prohibitions of that act. Under Regulation K, these statutory exemptions are granted to so-called qualifying foreign banking organizations - those that derive more than half of their foreign business from banking and more than half of their banking business from outside the United States.

For purposes of the qualifying standard, "banking business" includes any permissible Regulation K activity conducted within the bank ownership chain.

The Fed's final revisions to Regulation K somewhat liberalize the qualifying requirements. For example, the Fed's decision to include life insurance underwriting and certain other activities noted above as "banking business" (permissible Regulation K activities), makes it a bit easier for a foreign organization to satisfy the qualifying test.

The Fed has also agreed to exempt certain foreign banking organizations, on a case-by-case basis, from the qualifying foreign banking organization standard "to prevent hardships to foreign financial services companies that are engaged largely in activities permissible to U.S. bank holding companies abroad." However, the Fed does not intend to exercise this new flexibility to exempt predominantly foreign industrial or commercial companies or companies that conduct most of their commercial banking business in the United States.

In making a case-by-case determination for a previously qualifying organization that falls out of compliance with the qualifying standard, the Fed will permit the organization to continue to conduct activities in the United States and make acquisitions abroad until such time as the Fed acts on the request for a special qualifying exemption.

Export Trading Companies

The Fed has revised Regulation K to incorporate the 1986 amendments to the Export Trading Act. These revisions amend the revenue test used to determine whether an export trading company is a permissible investment for a U.S. banking organization.

Under the revised Regulation K an export trading company qualifies as a permissible investment so long as it derives one-third of its revenues in each consecutive four-year period from export activities, and derives more revenues in each four-year period from export activities than it derives from import activities.

In sum, the Fed has made some significant revisions to its Regulation K, expanding the opportunities for U.S. banking organizations abroad and the opportunities in the United States for foreign banking organizations.

However, several of the Fed's revisions - particularly as they relate to expanded powers - may well be impacted by the omnibus legislation wending its way through the Congress. It is a bit too early to profitably speculate just how the proposed legislation will further complicate Regulation K and these recently completed revisions.

Mr. Ludwig is a partner and Ms. Self is an associate in the Washington law firm of Covington & Burling.

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