Holding Corporations: Establishing the Best Structure for a Banking Corporation

I. Control Potential of a Holding Company
Holding corporations derive some protection from their detached status as non-owners. Despite its status, a holding company can reap the benefits of its detachment without loss of control. Under the Savings and Loan Holding Company Act of 1967, holding companies are allowed to control thrifts. Thrifts are saving and loan associations that take deposits for loan obligations. (Black’s Law Dictionary). Thrift Associations give the holding company control of assets, but they are also heavily regulated under the supervision of the Office of Thrift Supervision. Out of the 1300 thrifts regulated by OTS, approximately half are controlled by holding companies. (Office of Thrift Supervision).
The Gramm-Leach-Bliley Act authorizes greater control for financial holding Corporations (FHC)s. Under older guidelines, holding corporations were only permitted to be “passive” and operate subsidiaries through “routine management.” (Dunham). FHCs may now become “full participants in the business of organizing, marketing, managing and investing in private equity funds and … an insurance holding company [may] remain in the set businesses after acquiring a bank.” (Dunham at p. 5).
Thrift Associations are frequently thrown into the general category of banking. (Investopedia.com). However, under the Bank Holding Act of 1956 (12 U.S.C. § 1841), thrifts engaged in insurance activities are not considered banks. Rather, they are institutions or associations. In fact, the Gramm-Leach-Bliley Act discussed below specifically addresses bank holding companies engaged in non-banking activities. A FHC may acquire control of 100 percent of a company’s voting rights, but may not hold the company interests in a depository institution which is a subsidiary of the FHC. (Duhham at p.5)
A recent controversy has arisen regarding the ability of holding corporations to gain too much control of the banking industry through thrifts. The Riegle-Neal Interstate Banking Act prohibits bank holding companies from obtaining more than 10 percent of U.S. deposits by purchasing other banks. (Taggart). Through thrifts, holding corporations can manipulate a loophole that would give them control over more than 10 percent of U.S. deposits. (Taggart). Wachovia Corporation’s recent attempt to purchase a California based bank recently raised concern over this issue. However, even if the acquisition does go through, Wachovia will not come close to the 10 percent limit. (Taggart).

II. Diversification
Section 4(c)(8) of the Bank Holding Company Act (BHC Act) permits bank holding companies (BHC)s to engage in non-banking activities as long as they are “closely related to banking.” The close relation to banking requirement essentially restricts BHC activities to insurance related activities, but does not allow a BHC to underwrite insurance. These holding company activities are largely regulated by state law. (Dunham at p.5).
The Gramm-Leach-Bliley Act of 1999 is the legislation that initially permitted a commercial bank and an insurer to operate under a single holding corporation. Prior to the Gramm-Leach-Bliley Act, an insurance holding company could not own a commercial bank. An insurance company could own one thrift under the old rules. Now, restrictions are derived from the BHC Act which regulates affiliations between the bank holding companies and insurance companies. (Dunham at p. 2).
Under the Gramm-Leach-Bliley Act, it is highly advantageous for a BHC to become certified as a financial holding company (FHC). A BHC is certified as an FHC through the Board of Governors of the Federal Reserve System (The Board). (Dunham at p.4). The Board has been allocated extensive power to expand FHC activities. (Dunham). The Board may even veto proposals by the Treasury Department to authorize new activities.
Through investment in insurance sectors and banking sectors, holding companies have the greatest potential for diversification. “Insurance companies will be the FHC subsidiaries that have the greatest flexibility to make venture capital and merchant banking investments in non-financial businesses.” (Dunham at p.6). However, the insurance market has changed drastically over the last several years. (Eslick at p.4). Large insurance companies have consolidated and now approximately “20 percent of brokers…drive 80 percent of the volume.” (Eslick).
Holding corporations are restricted in their operations by the Gramm-Leech-Bliley Act, but their defined roles can be used efficiently to find an appropriate market. One function that satisfies the “closely related to banking” requirement of the BHC Act is to operate a limited purpose trust company. Limited purpose trust companies operate entirely in a fiduciary capacity and therefore do not qualify as “banks” under the BHC Act. (Dunham at p.4)
While holding corporations typically maintain expertise in one general area such as farming or home loans, there is potential for corporations to diversify their sector portfolio. Holding corporations in different markets typically have dissimilar concerns that will impact the structure of their organization. For instance, Cascade Bancorp, the holding corporation for Farmers & Merchants State Bank of Idaho, has done well enough to split its stock. (Idaho Business Review Staff Report). Conversely, SLM, otherwise known as Sallie Mae, a student loan corporation, may be negatively impacted by potential interest rate cuts under the upcoming reauthorization of the Higher Education Act.

III. Political Climate
Holding companies like Sallie Mae are subject to ramifications from political change in Washington. For SLM, profitability is regulated by Congress. (McLean). Student loan interest rates are set by congressional legislation. (McLean). Sallie Mae, however, has not been encumbered by cuts from the student-loan program. In fact, its stock has done quite well since the company has been protected by legislation from the seventies which guarantees a 9.5 percent return to student lenders. (McLean at p. 3).
Political ramifications and pertinent legislation are essential to understanding the structure of a business. Typically, interest rates are the focus of corporate volatility, but direct legislation and indirect legislation must be predicted in a business plan. An example of direct legislation for an oil company would be the opening of oil reserves. An example of indirect legislation might be the effects of taxation aimed (intentionally or unintentionally) at a particular market.

IV. Taxation
Flexibility is the main benefit derived from a holding corporation, but there are other factors that should be considered in light of the risks that a holding corporation will face. A Start up business may be hesitant to structure itself as a corporation. C-corporations are burdened by double taxation. A preferred arrangement for a holding company may be to structure itself as an s-corporation to avoid double taxation. S-corporations are taxed like partnerships. Profits and losses are “passed through” to the shareholders. (Minassian). There are, however, complex guidelines that s-corporations must follow. (Minassian).

VI. Corporate Governance
Recent legislation has attempted to control corporate wrongdoing through regulation aimed at parent corporations. Some legislation has imposed criminal sanctions on corporate actors that cause injury or death through negligence, willful, or malicious intent. (McGillivray).
The question of corporate responsibility raises the age old debate over whether responsibility should be left to the market or state-imposed legal ramifications. Market theories depend on responsibility to shareholders for upholding ethical conduct. There are various theories on how much state control should be exercised over corporations. At the most extreme end, enterprise liability holds all parties involved responsible for the wrongdoing of a company. However, the center of the debate is balanced on requiring some degree of knowledge related to culpable conduct before holding parties responsible.
On the international front, global regulation is considered in three models. The neo-classic or liberal model relies on entirely free markets and loose state regulation to control corporations. (Backer). The second model, moral restraint, relies entirely on moral responsibility to control corporate behavior. (Backer). The third model, the control model, polices corporate conduct through direct and indirect regulation. (Backer).
The debate over how to approach corporate governance is focused on corporations that have holding company structures. A holding company can avoid responsibility for the actions of its holdings or actors at lower levels. However, more regulation is forthcoming for corporations that exercise control over offending companies or have knowledge of their actions.
In forming corporate structures, many companies have preempted domestic legislation by creating their own policies to prevent association with corporate wrongdoing. These policies, often referred to as soft law, impose requirements on contractors and sub-entities.
VII. Foreign Impact
U.S. holding corporations have recently raised objection to guidelines regarding criteria to become a financial holding company (FHC). (Dunham at p. 9). Foreign corporations that own subsidiary banks in the U.S. are subject to the Bank Holding Company Act (BHCA). (Dunham). Most foreign banks operating in the U.S. do not operate through bank subsidiaries. In order to qualify as a FHC, foreign banks must be “well capitalized” and “well managed.” (Dunham). Domestic corporations have objected to the method for determining a “well-capitalized” corporation. The method domestic corporations object to requires the corporation’s Tier 1 capital to hold assets leverage ratio to be at least 3 percent. (Dunham). Domestic corporations insist that the Basel Accord on banking supervision, does not contemplate a leverage ratio requirement. (Dunham). Since “foreign banks do not operate under a holding company structure, the assets and liabilities of a foreign bank’s affiliates will necessarily be incorporated into the bank’s consolidated financial statements.” (Dunham) The Board is currently addressing concerns over this matter by developing alternative methods. (Dunham at p.10).

Conclusion
Start up businesses must structure themselves in a way that reflects their long term expectations. The initial decision to form a corporation may be based on considerations such as tax implications or desire to protect resources. However, corporate structure decisions should also consider control, flexibility, and political climate.
Recent legislation has helped holding companies to be more flexible and maintain control over subsidiary companies. A thorough understanding of the direct and indirect legislation affecting markets is necessary to operate efficiently. Moreover, an understanding of political climate is necessary to predict corporate implications.
A holding corporation structure will provide the flexibility and control necessary to compete in today’s markets. However, the specifics of the market(s) involved and the degrees of control exercised will be determinative of the business’s success.