This Update provides an overview of the Rule, including how it relates to both the Federal Reserve’s current control regime and the Proposal. We focus primarily on explaining the various evaluation criteria the Federal Reserve uses to assess control, including the impact they may have on specific parts of the industry. Following this overview, we describe certain key takeaways for entities affected by the Rule.
Elements of Control Determinations Under the Rule
Control is the principal metric by which the Federal Reserve determines whether an investor in a depository institution is subject to the restrictions of the BHCA (or the HOLA) and, correspondingly, whether a company in which a depository institution holding company invests becomes subject to such restrictions. It is also used to determine which entities are subject to certain related regulatory regimes, such as the Volcker Rule.
There are three main tests of control under the BHCA and the HOLA, two of which are clear, bright-line tests. First, a company is deemed to control another company when the first company controls 25 percent or more of a class of voting securities of the second company. Second, a company is deemed to control another company when the first company controls a majority of the second company’s board of directors (or the equivalent of the board of directors). The third test of control, whether a company exercises a “controlling influence” over another company, is the principal focus of the Rule. As this test is included in the definition of “control” in both statutes, the Rule affects both bank holding companies (BHCs) and savings and loan holding companies (SLHCs).3
The Rule is structured around 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 noncontrol of the second company under the controlling influence test. These tiers — which are less than 5 percent, between 5 percent and 9.99 percent, between 10 percent and 14.99 percent, and between 15 percent and 24.99 percent — formalize the longstanding general view of the Federal Reserve that as the number 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, summarizes these presumptions:
Under this framework, a control determination is based on the percentage of voting securities held by the first entity (listed on the horizontal axis in the table) and the presence of at least one additional factor (listed on the vertical axis). As adopted, this tiered framework is consistent with the Proposal, with a number of exceptions, detailed in the sections below.
The Federal Reserve has expressed the belief that the Rule principally codifies historical guidance and precedents regarding control while incorporating certain limited adjustments. Consistent with this belief, the Federal Reserve has left existing policy statements related to control in place to the extent that such policy statements are consistent with the Rule.4 However, the adoption of the Rule does not limit the discretion of the Federal Reserve to find that a controlling influence exists in circumstances where it would not be presumed by the Rule, based upon the Federal Reserve’s historical approach or a review of facts and circumstances.5 The Rule also generally leaves intact the Federal Reserve’s procedures for making a formal finding regarding control, with minor changes concerning the presentation of additional information to the Federal Reserve following a preliminary determination.
The Federal Reserve has also opted against conforming the interpretations of control used under Regulation O, Regulation W and the Change in Bank Control Act to the interpretation set out in the Rule. While the Federal Reserve acknowledges that doing so would create greater regulatory efficiency, and therefore that it may do so in the future, for now the Federal Reserve has stated that each set of interpretations arises from different provisions of law, are intended to address different policy concerns, and therefore should remain separate.
Permissible Total Equity Holdings
The Rule amends the control presumptions that relate to the total equity that a company may hold in a second company without being deemed to control. The presumption that applies will differ depending on whether the BHCA or the HOLA is implicated, due to differences in the language of the respective statutes. Companies governed by the BHCA will be presumed to control a second company, notwithstanding whether any other control presumption has been triggered, if they hold one-third or more of the total equity of a second company.6 Companies governed by the HOLA will be deemed to control a second company, notwithstanding whether any other control presumption has been triggered, if they hold more than 25 percent of the total equity of a second company. The Proposal applied the same thresholds for both BHCs and SLHCs and included a control presumption that applied when total equity holdings in a second company equaled or exceeded 25 percent and holdings of any class of voting securities equaled or exceeded 15 percent.
Calculation of Total Equity
In adopting the Rule, the Federal Reserve largely preserved the U.S. generally accepted accounting principles (GAAP)-based methodology contained in the Proposal for calculating the total equity percentage that a company holds of another company. This includes the mechanics from the Proposal for treating certain types of debt as equity, if such interests are the functional equivalent thereof. However, the Rule adds a symmetrical provision, “expected to be used rarely,”7 under which equity instruments held by a company may be excluded from the total equity calculation if they are functionally equivalent to debt. The Rule also departs from the Proposal in requiring that a company calculate total equity that it holds in a second company only at the time of its investment and when it acquires control over additional equity, but not when it sells or disposes of equity in the second company.
The Rule also generally adopts the Proposal’s approach with respect to options, warrants and convertible securities, by requiring that a company look through such instruments. Under the Rule, a company is deemed to control the maximum number of securities underlying a convertible instrument that could be controlled if the instrument is converted or exchanged. While there are limited exceptions for securities convertible on particular types of transfers, such as public offerings, generally this codifies the Federal Reserve’s prior position on options, warrants and convertible securities.
Presumption of Noncontrol
The Rule maintains the expanded rebuttable presumption of noncontrol contained in the Proposal. Previously, a company that controlled less than 5 percent of any class of voting securities of a second company was presumed not to control the second company. Under the Rule, this presumption is expanded to cover any company that (i) controls less than 10 percent 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 the applicable ownership level.
Traditionally, the Federal Reserve has viewed significant business relationships as indicia of control, due to the level of influence that a company may wield over another as a result of a sizable business relationship. The Rule provides additional clarity about how significant a company’s business relationships must be to result in a controlling influence. The Rule and the Proposal are largely consistent with respect to the treatment of business relationships, with one key exception. Under the Proposal, control would have been determined by a combination of the percentage of voting securities that a company held in a second company and the aggregate percentage of total revenues or expenses that the business relationship generated for the first or second company. Under the Rule, the latter portion of this test now only considers the aggregate percentage of total revenues or expenses that the business relationship generates for the second company (that is, the one potentially controlled by the other).
Under the Rule, there is no presumption of control based on business relationships if a company holds less than 5 percent of a class of voting securities of a second company. If a company controls 5 percent to 9.99 percent of any class of voting securities in a second company, those companies may have business relationships that generate, in the aggregate, less than 10 percent of the total annual revenues or expenses of the second company. If a company controls 10 percent to 14.99 percent of a class of voting securities of a second company, the companies may have business relationships that generate, in the aggregate, less than 5 percent of the total annual revenues or expenses of the second company. Finally, if a company controls 15 percent to 24.99 percent of a class of voting securities of a second company, the companies may have business relationships that generate, in the aggregate, less than 2 percent of the total annual revenues or expenses of the second company.
These limitations will continue to pose significant hurdles for strategic investments by banks and savings and loan holding companies in fintech startups and other early-stage companies. The Federal Reserve has also left undefined practical considerations in the application of measurements of total annual revenues and expenses, including the timing for receipt of financial information by the “controlling” company and its ability to act on that information.
Further, consistent with the Proposal, business relationships where a company controls 10 percent or more of a second company must be on market terms or the business relationship would trigger a control presumption.
The Rule, consistent with the Proposal, significantly updates Federal Reserve policy relating to director representation. Previously, the Federal Reserve generally restricted noncontrolling investors with 10 percent or more of a class of voting securities to a single board seat, absent a larger shareholder in the company in which the investment is made. Under the Rule, an investor can control up to (but less than) half of the board seats, provided the investor holds less than 5 percent of all classes of voting shares of the company. If an investor holds 5 percent or more of a class of voting shares of the other company, the investor can have up to (but less than) a quarter of the board seats. An investor’s director can serve as the board’s chairperson without triggering a presumption of control provided the investor holds no more than 14.99 percent of a class of voting securities of the second company. An investor’s representatives must constitute less than a quarter of a committee with the power to bind the company or a control presumption would be triggered if the investor holds 10 percent or more of a class of voting securities of the second company. The investor’s board representatives may serve on such committees without triggering a presumption of control if the investor holds less than such amount.
A director is considered a representative of an investor if the director represents the interest of a first company through serving on the board of a second. The Rule includes a number of nonexclusive examples, including if the director (i) is a director, officer or employee of the investor, (ii) held any of the aforementioned positions in the preceding two years or (iii) was nominated or proposed by the investor to be the director of the second company. While a director must represent the interest of a first company to be considered affiliated with an investor, investors should bear the last of these three examples in mind, as it indicates that the Federal Reserve may take a more aggressive stance in assessing whether a director is a representative of an investor in certain circumstances, such as if the company recommends the director in a formal or official manner.
The Rule is consistent with the Proposal with respect to management interlocks. A management interlock exists when an “agent” of a company serves as a management official of a second company. Under the Rule, limited interlocks do not result in a presumption of control when a company controls less than 15 percent of all classes of voting securities of a second company. However, in cases where a company controls 5 percent or more of a class of 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. For this purpose, the Federal Reserve uses a definition of “senior management official” — any person who participates or has the authority to participate (other than in the capacity as a director) in major policymaking functions of a company — that is consistent with the definition of “executive officer” in Regulation O.
Limitations on Business Decision Making
Like the Proposal, the Rule permits an investor to impose only a narrow set of limitations by contract on a second company before the Federal Reserve would find a controlling influence. If an investor holds 5 percent or more of a class of voting securities of a second company, such investor will be presumed to control if the investor has any “limiting contractual right” with respect to the second company. A limiting contractual right is any right that would allow an investor to “restrict significantly, directly or indirectly, the discretion of the second company, including its senior management officials and directors, over operational and policy decisions.”8 The Rule contains a series of nonexclusive examples of what constitutes a limiting contractual right as well as a series of nonexclusive examples of what would not constitute a limiting contractual right.
Lenders that ordinarily take warrants as part of loan transactions will need to be particularly cautious in dealing with this provision of the Rule. Given that the Federal Reserve, in making a control determination, will attribute the equity for which warrants may be exercised to the warrant holders, warrants representing 5 percent or more of a class of voting securities could, in combination with ordinary loan covenants, result in the lender’s being deemed to control the borrower. Therefore, lenders seeking such covenants should ensure that they do not take warrants that, if exercised, would result in the lender’s holding in excess of 4.99 percent of a class of voting securities.
The Rule includes an exception for limiting contractual rights arising as part of an agreement to merge with or make a controlling investment in the second company, designed to ensure that the company continues to operate in the ordinary course until closing, or that requires the second company to take an act necessary to close. Such transactions must be reasonably expected to close (and the relevant contractual limiting rights to terminate) within one year.
At any ownership level (including less than 5 percent of a class of voting securities), an investor is presumed to control a second company, if the investor enters into a management contract or similar agreement with the second company (other than agreeing to serve as an investment adviser), through which the investor exercises significant influence or discretion over the management, operations or core business of the second company. Examples of such agreements include where a company acts as managing member, trustee or general partner of the second company.
BHCA/HOLA Activity Restriction Limitations
Of particular note, the Rule includes “a prohibition on entering into new lines of business, making substantial changes to or discontinuing lines of business” as examples of limiting contractual rights.9 The Federal Reserve acknowledges that this may interfere with existing contractual provisions meant to ensure a company’s compliance with the BHCA or the HOLA, a precaution that some BHC and SLHC investors take to protect investments in case such investment is deemed to be controlling. By way of contrast, though, the Federal Reserve acknowledges that a “reasonable and non-punitive mechanism for an investing company to reduce its investment to comply with the activities restrictions of the BHC Act or the HOLA generally would not be a limiting contractual right.”10
With respect to investment advisers, the Rule adopts the provisions of the Proposal, except for a proposed exemption for registered investment companies. Under the Rule, a company that serves as investment adviser to an investment fund is presumed to control the fund if the company controls 5 percent or more of any class of the fund’s voting securities or 25 percent or more of the fund’s total equity. This eliminates existing guidance that allowed investment advisers to hold up to 24.9 percent of the voting securities of a fund under limited circumstances. However, the Rule does provide an exemption for seeding new funds: An adviser may exceed the aforementioned thresholds without being deemed to control a fund that the adviser organized and sponsored during the preceding 12 months.
The Rule retains the same standards relating to proxy solicitations as in the Proposal. As such, an investor, without regard to the size of its holdings in a second company, is permitted to solicit issue proxies — that is, proxies unrelated to the election of directors — without triggering a presumption of control. However, an investor that controls 10 percent or more of a class of voting securities would be presumed to control a second company in the event that such investor solicits proxies to appoint a number of directors equaling or 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).
The Rule adopts the Proposal’s approach towards divestiture in full. Historically, the Federal Reserve applied a considerably stricter standard when evaluating control in the context of a controlling party seeking to partially exit its investment, and thereby take a noncontrolling position, than when evaluating control for purposes of an initial investment. This determination was somewhat subjective and based in significant part on the percentage of voting securities that a company retained after divestiture.
The Rule provides two mechanisms by which a company can divest a controlling stake. First, the company can divest securities so that it holds less than 15 percent of a class of voting securities of the second company. Under such scenario, the first company will no longer be presumed to control the second provided no other presumptions of control are triggered at that level and the first company does not increase its holdings above 15 percent during the two years following divestiture. Second, the company can divest securities so that it holds less than 25 percent but at least 15 percent of a class of voting securities of the second company and wait two years after divestiture. After two years have passed, the first company will not be presumed to control, provided no other presumptions of control are triggered. Moreover, even if a company does not satisfy these new divestiture presumptions, a company will not be presumed to control a second company, in the divestiture context, if 50 percent or more of each class of the second company’s voting securities is controlled by a person or company that is not an affiliate of the first company.
The Proposal sought comment regarding whether a company should be presumed to control another company that it accounts for under the equity method of accounting. The Rule does not adopt this standard. However, the Rule does retain the new presumption from the Proposal, under which a company consolidating a second company on its financial statements prepared under U.S. GAAP gives rise to a presumption of control. This means that entities not controlled in a conventional business sense, such as variable interest entities, would be deemed to be controlled. While this presumption applies only to companies consolidated under U.S. GAAP, the Federal Reserve noted that it is “likely to have control concerns where a company consolidates another company on its financial statements under another accounting standard.”11
As with the Proposal, we believe that the Rule is a step in the right direction by the Federal Reserve. Although the Federal Reserve has not made certain revisions requested by commenters that would make the Rule more workable — for example, certain accounting-based consolidation provisions remain intact — the Federal Reserve has made other changes that do enhance the usability and practicality of the provisions therein. Overall, while not all issues raised by public comments were sufficiently addressed, we continue to see the Rule as a positive for the industry, as it provides needed clarity for companies in structuring potential investments and business relationships.
Under the Rule, companies have maximum flexibility when making investments of less than 5 percent of a class of voting securities. In conjunction with such investments, a BHC may own up to one-third of the total equity of a second company (through additional nonvoting securities) and may control up to (but less than) 50 percent of the board of directors of the second company. Companies must exercise caution as the percentage of a class of voting securities held rises, though, recognizing that the types of business relationships that may trigger a presumption of control become less substantial as holdings of voting securities rise. As such, it is important that any company seeking to acquire between 5 percent and 24.99 percent of a class of voting securities carefully vet all components of a transaction before entering into a business or other relationship and monitor the compliance of any such investment on an ongoing basis thereafter.
We think there are two areas of liberalization of note in the Rule that will particularly benefit banking and financial services industry participants. First, the Rule increases the number of board seats that a company may hold in a second company before being presumed to control. This will increase accountability associated with investments that a company may make, for example, in fintech companies, by allowing an investor a greater say in the governance of a company. Second, the Rule provides greater flexibility around management interlocks when a company holds less than 15 percent of a class of voting securities of a second company. This too will increase accountability associated with investments, particularly given the lack of control presumptions relating to interlocks where an investor holds less than 5 percent of a class of voting securities of a second company.
We also think that liberalization regarding the soliciting of proxies may result in changes to industry dynamics and likely will result in greater proxy activity. As a result of the Rule, BHCs and SLHCs may elect to take defensive measures, whether by changing corporate policy and governance documents or by engaging in preemptive market actions, such as buybacks. In turn, given the liberalization around board representation, investors may engage in a greater number of proxy contests, whether by seeking increased board representation or by seeking changes to corporate policy on a stand-alone basis. In doing so, investors must remain careful not to trigger any other presumptions of control established by the Rule. Investors must also be mindful that the Federal Reserve has reserved the right to find that there is control in specific facts and circumstances even if none of the formal presumptions of control has been triggered.
Additionally, investors that have entered into passivity commitments with the Federal Reserve should note that it has indicated a willingness to consider granting relief from such commitments in many, but not all, circumstances. Investors subject to such commitments should assess whether to seek such relief to obtain greater flexibility in protecting their investments.
Finally, the Rule takes effect on April 1, without any formal grandfathering provisions or transition period. While the Federal Reserve has indicated that it is unlikely to revisit control determinations with respect to structures it has previously reviewed and that have not materially changed, many investments have been made both in and by BHCs and SLHCs that were analyzed from a control perspective without specific review from the Federal Reserve. Accordingly, BHCs and SLHCs need to immediately review the contractual terms of existing direct and indirect investments, and assess the expenses and revenues associated with applicable business relationships, to determine whether those investments or relationships will trigger a presumption of control. If such investments or relationships do trigger a presumption of control, it is imperative that BHCs and SLHCs develop a plan to restructure those investments and relationships to ensure that each BHC or SLHC remains in compliance with the BHCA or the HOLA, as applicable.
1 Federal Reserve, Draft Final Rule, Control and Divestiture Proceedings (January 30, 2020).
2 84 Fed. Reg. 21634 (May 14, 2019). Our client alert discussing the proposed rule is available here: https://www.sidley.com/en/insights/newsupdates/2019/04/federal-reserve-proposes-changes-to-control-framework.
3 As explained further below, SLHCs are treated slightly differently under the Rule due to a slight difference between the definitions of “control” in BHCA and the HOLA.
4 Rule Preamble at n. 23.
5 Rule Preamble at n. 24 & 35.
6 Rule at 12 C.F.R. § 225.32(c).
7 Rule Preamble at 73.
8 Rule at 12 C.F.R. §§ 225.31(e)(5), 238.21(e)(5).
9 Rule at 12 C.F.R. §§ 225.31(e)(5)(i)(A) and238.21(e)(5)(i)(A).
10 Rule Preamble at 78.
11 Rule Preamble at 46.
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