Federal Reserve Proposes Changes to "Control" Framework

Summary of Notable Elements of the Proposal

Tiered Presumptions

The central element of the Proposal is a set of tiered presumptions for determining when an equity investment by one company in a class of voting securities of another company, in combination with other factors, would be presumed to result in control or non-control of the second company. These tiers — which are less than 5%, between 5% and 9.99%, between 10% and 14.99%, and between 15% and 24.99% — formalize the longstanding general view of the Federal Reserve that as the amount of voting securities that a company holds of a second company increases, the extent of relationships between the two companies that can exist without control decreases. The following chart, which the Federal Reserve included as an appendix to the Proposal, summarizes these presumptions:

According to the Federal Reserve, this inverse relationship is a logical outgrowth of the framework established in the BHCA and the HOLA. The Proposal states that “where a company’s voting ownership percentage falls within [the] range [from 0% to 25%] is one of the most salient considerations for determining whether the first company controls the second company.”³  Nevertheless, it is important to remember that these are only regulatory presumptions. The Federal Reserve has expressly reserved the authority to make control determinations that do not accord with the presumptions, based on the facts and circumstances of a particular investment or relationship.

Presumption of Non-Control

The Proposal expands the Federal Reserve’s current rebuttable presumption of non-control. Currently, a company that controls less than 5% of any class of voting securities of a second company is presumed not to control the second company. The Proposal further extends a presumption of non-control to a company that (i) controls less than 10% of every class of voting securities of a second company and (ii) is not presumed to control the second company under any of the control presumptions that apply at that ownership level.

Director Representation

The Proposal liberalizes Federal Reserve policy in the area of director representation. Under existing precedent, the Federal Reserve generally has not permitted a non-controlling investor with 10% or more of a class of voting securities to control more than one seat on another company’s board except where there is a larger shareholder in the other company. In such a situation, a non-controlling investor may control a maximum of two seats, and generally only in proportion to its overall voting stake.

Under the proposed rule, a company that holds less than 5% of a class of voting securities in a second company, and otherwise remains in a non-control position, is permitted to have any number of board seats as long as it is less than a majority of the board of directors of the second company (a majority of the board constitutes one of the bright-line thresholds for control). The Proposal also provides that a company that holds 5% or more of a class of voting securities, but less than 25%, may hold less than a quarter of the board seats and remain in a non-control position. However, a company that holds 5% or more of a class of voting securities is also presumed to control a second company if the first company may, by virtue of the company’s board seats, make or block operational or policy decisions. This could occur, for example, where a board has supermajority voting requirements or directors have individual veto rights. A similar presumption of control applies when a company holds 10% or more of any class of voting securities in a second company, and occupies more than 25% of the positions on a board committee that has the power to bind the company.

A director representative of a company may serve as chair of the board of a second company without triggering a presumption of control if the first company controls less than 15% of any class of voting securities of the second.

Proxy Solicitations

The Proposal liberalizes the Federal Reserve’s policies relating to proxy solicitations. Historically, the Federal Reserve has believed control concerns arise when a company controls 10% or more of a class of voting securities in a second company and solicits proxies to replace the existing directors of the second company. Under the Proposal, a presumption of control could still be triggered at the same control threshold (when a company controls 10% or more of a class of voting securities) but would apply only when the company solicits proxies to appoint a number of directors exceeding a quarter of the total directors of the second company (that is, greater than the number of directors that the first company may appoint by virtue of its holdings). Importantly, the presumptions would not apply to solicitations of proxies unrelated to the election of directors.

Business Relationships

The Proposal articulates definitive standards for when a business relationship would result in a controlling influence and thus trigger a presumption of control. The Federal Reserve has traditionally permitted a company to enter into a business relationship with a second company that is “quantitatively limited and qualitatively nonmaterial” without being presumed to control the second company.⁴  However, the Federal Reserve has viewed more significant business relationships as an indicia of control, due to the level of influence that a company may wield over another as a result of a sizable business relationship.

Under the Proposal, if a company controls 5% to 9.99% of any class of voting securities in a second company, those companies may have business relationships that generate, in the aggregate, less than 10% of the total revenues or expenses of either the first or the second company. If a company controls 10% to 14.99% of a class of voting securities of a second company, the companies may have business relationships that generate, in the aggregate, less than 5% of the total revenues or expenses of either company. Finally, if a company controls 15% or more of a class of voting securities of a second company, the companies may have business relationships that generate, in the aggregate, less than 2% of the total revenues or expenses of either company. Further, business relationships where a company controls 10% or more of a second company must be on market terms, otherwise the business relationship would trigger a control presumption.

Management Interlocks

The Proposal liberalizes the Federal Reserve’s prior approach to management interlocks. Previously, the Federal Reserve took a conservative view, generally considering management interlocks a strong indicia of control. A management interlock exists when an “agent” of a company serves as a management official of a second company, which could allow the first company to exercise a controlling influence over the second.

The Proposal permits interlocks when a company controls less than 15% of the voting securities of a second company. However, in cases where a company controls 5% or more of the voting securities of a second company, a presumption of control applies if there is more than one senior management interlock or if the employee with the interlock is the chief executive officer (or equivalent) of the second company.

Total Equity Determination (Size of Holdings and How to Calculate)

The Proposal codifies much of the existing guidance relating to total equity determinations and provides a prescriptive formula for calculating total equity. Existing Federal Reserve guidance generally permits a company to control less than one-third of the total equity of another company without being deemed to control that second company, provided that the first company controls less than 15% of any class of voting securities of the second. If a company controls 15% or more of a class of voting securities, the company’s total equity holdings in the second company need to be less than 25%. Further, under existing policy, a company would generally be deemed to control any securities in a second company that the first either has a contractual right to acquire now or in the future or which the first company would automatically acquire upon the occurrence of a future event.

The Proposal largely codifies this guidance into a formal presumption. Under the Proposal, the control presumptions relating to the amount of total equity a company may control in a second company remain the same. To calculate a company’s total equity holdings in another company, the first company is, consistent with Federal Reserve precedent, generally expected to include in its total holdings the maximum amount of securities that the company could control upon the exercise or conversion of any options, warrants or convertible instruments that the company controls, presuming that no other party elected to exercise its rights (except where such rights must be exercised by all holders simultaneously). The Proposal also includes a prescriptive formula for calculating total equity, which is linked to the equity calculations made under U.S. generally accepted accounting principles (GAAP). This is the first public guidance from the Federal Reserve on this point and will need to be carefully evaluated in the context of analyzing control, especially for early-stage or other small companies that have small balance sheets.

Divestiture

The Proposal substantially reexamines and alters the Federal Reserve’s prior practice regarding divestiture of control positions. The Federal Reserve often took conservative positions regarding companies that had control of a second company but sold sufficient securities to bring the first company’s holdings below the 25% threshold. For example, unless a divestiture brought the first company’s holdings of voting securities of the second company below 10% (or in some cases, below 5%), the Federal Reserve often continued to view a company that had previously controlled the second company as still being able to exercise a controlling influence over the second company, even after a divestiture. This meant that the Federal Reserve applied a stricter standard than when evaluating control for purposes of an initial investment and gave significant weight to the percentage of voting securities retained after the divestiture.

Under the new approach in the Proposal, if a company intends to divest a controlling stake, the company can either (i) divest securities so that it holds less than 15% of a class of voting securities of the second company and be presumed not to control (provided no other presumptions of control are triggered and it does not increase its holdings), or (ii) divest securities so that it holds less than 25% but at least 15% of a class of voting securities of the second company and wait two years after divestiture, at which point the first company will be presumed not to control (provided no other presumptions of control are triggered). In addition, even if a company does not satisfy the new divestiture presumptions, a company may still be able to achieve a non-control position in circumstances where a majority of each class of voting securities of the second company are controlled by a single person or company that is not affiliated with the first company.

Accounting Consolidation

The Proposal introduces a new presumption for determining whether a company controls a second company: whether the first company consolidates the second company on financial statements prepared under U.S. GAAP.⁵  According to the Proposal, the Federal Reserve is adopting this presumption due to the GAAP standards’ encompassing situations where the consolidating entity (the first company) has a “controlling financial interest over the consolidated entity” (the second company), where a company can direct the activities of a second company that most significantly affect the second company’s performance and the first company receives the benefits therefrom or where the first company controls the second by contract.⁶ 

Key Observations and Takeaways

We believe the Proposal is a step in the right direction by the Federal Reserve. It increases clarity in control determinations, which we view as a positive for the industry. Fintech companies, investors in banking organizations, activist investors and banking organizations themselves should evaluate the Proposal and consider providing comments to the Federal Reserve during the comment period. While, as with any regulatory proposal, much will depend on how the Federal Reserve implements the Proposal once it is finalized, there are a few major conclusions one can draw now.

First, it is important to note the significant impact that the Proposal would have if adopted. As the BHCA definition of control is used in a variety of banking contexts — including, for example, the Volcker Rule — the Proposal would have a widespread effect on banking regulation.⁷ Institutions subject to the Federal Reserve’s control rules would need to carefully evaluate whether any aspects of the Proposal would, if adopted, require them to change positions they have previously taken regarding control in many contexts.

Second, given the way the control presumptions are structured, the Proposal provides significant advantages to investment structures in which a company controls less than 5% of a class of voting securities of a second company. The Proposal contains very few control presumptions that apply below the 5% threshold. For banking organizations investing in nonbanks, particularly banking organizations investing in fintech companies, remaining below 5% of a class of voting securities means there will be no presumption of control due to the size of a business relationship with the company in which an investment is being made, although a case-by-case review of unusually significant relationships is still possible. For investors in banking organizations, the presumptions mean it will be easier to place representatives on the board of a banking organization without being deemed to control that banking organization (and thereby becoming subject to the activity restrictions of either the BHCA or the HOLA).

Finally, the presumptions relating to board representation and proxy contests provide more flexibility to activist investors, and may result in more proxy activity. As a general matter, this may lead banks, BHCs, and SLHCs to take defensive measures, whether in the form of preemptive market actions or through formal changes to corporate policy or governance documents. More specifically, the difference between treatment of proxy solicitations for the election of directors and those for changing corporate policies more generally may result in activists’ attempting to take control of a limited number of board seats, and using proxy contests over corporate policy to produce the changes the investor seeks to make.