Federal Reserve Issues Final Rule on Control Regulations

On January 30, 2020, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) approved a final rule (the “Final Rule”) revising the regulations related to the determination of “control” of banks under the Bank Holding Company Act (“BHC Act”)[1] and of federal savings associations under the Home Owners’ Loan Act (“HOLA”).[2] The Final Rule is intended to improve transparency and predictability relating to control questions.[3] However, this remains a complex area, and this Client Alert is intended to provide only an overview.

The Final Rule will be effective on April 1, 2020.  It follows the publication of a proposed rule released on April 23, 2019 (the “Proposed Rule”),[4] and the receipt of considerable public comment. The Final Rule is largely consistent with the Proposed Rule, which is summarized in our prior Client Alert.

As noted in the preamble to the Final Rule (the “Preamble”), the Final Rule is intended generally to reflect current Federal Reserve policy on control issues. Accordingly, the Final Rule does not grandfather existing investments nor provide for a transition period. The Federal Reserve does not expect to revisit structures it has already reviewed unless such structures are materially altered from the facts and circumstances of the original review.[5] Companies may need to consult with the Federal Reserve staff, especially in situations where they have concluded (without consultation with the Board) that no control exists but the Final Rule creates a presumption of control.

The revised control regulations do not change the control regime under the Change in Bank Control Act (“CIBCA”).[6] As noted in the Preamble, the CIBCA serves a different purpose than the BHC Act or HOLA: whereas the CIBCA requires filing a one-time notice, the latter two statutes impose a permanent regulatory status involving, among other requirements, activity restrictions, prudential regulation, periodic examinations, and reporting requirements. The Federal Reserve may in the future consider conforming regulations under the CIBCA.[7]

Background

The BHC Act applies to “bank holding companies,” which are defined to include any company that has control over a bank.[8] In addition, the restrictions and limitations contained in the BHC Act generally apply to any company (other than a bank) controlled by a bank holding company, since the investments and activities of any such company are generally attributed to the bank holding company itself.

Under the BHC Act, one company is deemed to control another if:

1. The first company has direct or indirect ownership, control, or power to vote 25% or more of the outstanding shares of any class of the voting securities of the second company;

2. The first company directly or indirectly controls the election of a majority of the second company’s directors, trustees, general partners, or others with similar management responsibilities under the second company’s organizing documents; or

3. The first company otherwise has the direct or indirect power to exercise a “controlling influence” over the second company’s management or policies.

The first and second prongs of the control definition create bright-line tests for control; the third prong requires a facts and circumstances analysis.

The BHC Act and Federal Reserve Regulation Y promulgated thereunder provide a number of presumptions upon which companies rely to avoid making controlling investments, including a presumption of non-control where a first company holds less than 5% of any class of voting securities of a second company. The Federal Reserve has also historically provided guidance regarding its controlling influence analysis through the issuance of various policy statements.[9] For example, the Federal Reserve issued a policy statement in 2008 that explains that the controlling influence analysis involves a review of certain “indicia of control,” such as total equity and business relationships. In addition, the Federal Reserve has made broad use of so-called “passivity commitments,” pursuant to which shareholders with minority stakes in banks commit to refrain from acquiring additional shares and exercising certain control attributes to have assurance that they will not be considered bank holding companies. This has led to the creation of a patchwork system, leaving some companies uncertain as to when their minority investments might result in control under the BHC Act. The Final Rule is designed to provide clarity in this area.  In addition, as discussed later in this Client Alert, the Final Rule is expected to dispense with the need for individually-negotiated passivity commitments except in special circumstances.

The Final Rule

Presumptions Related to Voting Equity

The Final Rule establishes rebuttable presumptions of control using a tiered approach. As a first company’s voting equity percentage in a second company increases, other control-related relationships and factors must decrease in order to avoid triggering a presumption of control.[10] These “tiered” presumptions, together with additional presumptions of control contained in the Final Rule and discussed elsewhere in this Client Alert, are intended to assist the Federal Reserve in making control determinations under the BHC Act and to assist companies in determining when they are presumed to be in control, directly or indirectly, of another company under the BHC Act. Nonetheless, the Federal Reserve retains the ability to make a “controlling influence” finding based on individual facts and circumstances and without a presumption of control having been triggered. However, the Federal Reserve does not generally expect that it will find control unless a presumption has been triggered.[11]

The Federal Reserve’s chart detailing this tiered framework of presumptions is republished below.

Summary of Tiered Presumptions

(Presumption triggered if any relationship exceeds the amount on the table)

Relationships and other Factors Considered under Tiered Presumptions

• Director Representation. As summarized in the chart, control will be presumed based on an inverse proportion of voting equity and director representation on the board of the second company by representatives of the first: the higher the voting equity percentage, the less Board representation to avoid a presumption of control. A director of the second company will be deemed a representative of the first company if he or she is deemed to represent the interests of the first company on the second company’s board. Several factors may be taken into account when considering whether a director is such a representative. For example, a director of the second company will be deemed to represent the interests of the first company if he or she is currently, or within the preceding two years has been, an officer, employee, or director of the first company, or has been nominated or proposed by the first company to be a director of the second company.[13]
• Business Relationships. The Federal Reserve has long acknowledged that one company can exercise control over another company because of material business relationships between the two. Under the Proposed Rule, the Federal Reserve was prepared to assess the materiality of a business relationship for control purposes based on whether material revenues and expenses of the second company came from business relations with the first company, or vice versa. However, in response to comments on the Proposed Rule, the Final Rule measures the materiality of a business relationship only by reference to the revenues or expenses of the second company to the extent derived from business relations with the first company.[14] In this situation, the concern is that the first company may attempt to leverage its business relationship to exercise influence over the second company; the more important the business relationship is to the second company, the greater the potential leverage.
• Senior Management Interlocks. As reflected in the chart, the greater the interlocks involving senior management officials,[15] the higher the propensity for the first company to control the second.
• Management Agreement. A first company is presumed to control a second company if the first company enters into any agreement (other than to serve as investment adviser, which is addressed separately in the Final Rule) enabling the first company to exercise significant influence over the general management, overall operations, or core business or policy decisions of the second company.[16] Examples include acting as a managing member of a limited liability company or a general partner of a partnership.  This is largely consistent with the current regulation.[17]
• Limiting Contractual Rights. As in the Proposed Rule, a limiting contractual right is “a contractual right of the first company that would allow the first company to restrict significantly, directly or indirectly, the discretion of the second company, including its senior management officials and directors, over operational and policy decisions of the second company.”[18] As this standard is subject to considerable interpretive latitude, the Final Rule lists non-exhaustive examples of what the Federal Reserve considers to be limiting contractual rights, together with examples of contractual provisions that would not be so considered.[19] The lists are intended to reflect a “distillation” of the Federal Reserve’s past practice and current understanding of what kind of contractual provisions are likely to raise controlling influence concerns.[20] What constitutes a limiting contractual right in individual cases, to the extent not contained in one of the listed examples, is likely to continue to raise uncertainties for investors in banks and bank holding companies.  
• Proxy Contest for Board Seats. A first company that owns 10% or more of the voting equity of a second company controls the second company if it proposes director nominees, in opposition to the second company’s slate, which, together with director representatives of the first company on the second company’s board, would comprise 25% of the board of the second company.
• Total Equity. A first company will be presumed to control the second company if the first company controls ¹/₃ or more of the total equity of the second company under the BHC Act, and more than 25% of the total equity under HOLA.[21] The Final Rule includes a methodology, substantially similar to that contained in the Proposed Rule, for calculating a first company’s total equity percentage in a second company organized as a stock corporation that prepares financial statements according to Generally Accepted Accounting Principles (“GAAP”).  Debt and other interests may be treated as equity if the interests are functionally equivalent to equity.[22] The converse is true as well; equity instruments that are functionally equivalent to debt may be excluded from total equity.[23] Under the Final Rule, a first company must include in its total equity calculation only equity securities that it controls directly or indirectly through its subsidiaries. This differs from the Proposed Rule, under which a first company would have been required to include a pro rata share of equity securities held by a non-subsidiary.[24] Also under the Final Rule, a first company only is required to calculate total equity at the time of its investment, i.e., when it acquires control over a second company.[25] 

Additional Presumptions and Exclusions

• Investment Funds. Under the Final Rule, an investment advisor to an investment fund is presumed to control the fund when it serves as an investment advisor to the fund and controls, directly or indirectly, or acting through one or more other persons, either (a) 5% or more of any class of voting securities of the investment fund or (b) 25% or more of the total equity of the investment fund.[26] These thresholds for control do not apply to an investment fund in formation during a one-year seeding period.[27]
• Accounting Consolidation. Under the Final Rule, as in the Proposed Rule, a first company that consolidates a second company under GAAP is presumed to control the second company.[28]
• Divestiture. Historically, the Federal Reserve has considered a first company that has controlled a second company to retain a controlling influence over the second company even after a substantial divestiture. Under the Final Rule, as under the Proposed Rule, there is a presumption of control where a first company previously controlled a second company during the preceding two years and the first company owned 15% or more of any class of voting securities of the second company.[29] This presumption generally does not apply where a first company sold a subsidiary to a third company and received stock of the third company as consideration.[30] In response to commenter requests for clarification, the Federal Reserve specifies in the Final Rule that this presumption will not apply where an unaffiliated individual or company will control 50% or more of each class of voting securities of the second company after divestiture by the first company.[31]
• Fiduciary Exception. Under the Final Rule, a first company is presumed not to control the securities of the second company that the first company holds in a fiduciary capacity, but where the second company is a depository institution or depository institution holding company, the fiduciary exemption does not apply where the first company has sole discretionary authority to vote the shares of the second company.[32]
• Shares Held by Management. Under the Proposed Rule, a first company would have been presumed to control a second company where (a) the first company controls at least 5% of any class of voting securities of the second company and (b) the senior management officials and directors of a first company, together with their immediate family members and the first company, own 25% or more of a class of voting securities of a second company (the “5%/25% presumption”).[33] The proposal was consistent with the current regulation,[34] but it provided an exception that applied where (a) a first company controls less than 15% of each class of voting securities of the second company and (b) the senior management officials, directors, and controlling shareholders of the first company, and immediate family members of such persons, control 50% or more of each class of voting securities of the second company.[35] The 5%/25% presumption was not adopted in the Final Rule, but the exception was retained. Under the Final Rule, a first company that controls 5% or more of any class of voting securities of a second company also controls any securities issued by the second company that are controlled by the senior management officials, directors, or controlling shareholders of the first company, or immediate family members of such individuals, subject to the aforesaid exception.[36]

Control of Securities

• Ownership & Control.  As in the Proposed Rule, under the Final Rule, a company that owns or holds, or has power to vote a security, or has the power to sell, transfer, pledge, or otherwise dispose of the security, is deemed to control the security. A company also is deemed to control securities that it owns, controls or holds in a fiduciary capacity for the benefit of the company (or any of its subsidiaries) or in a fiduciary capacity for the benefit of shareholders, member or employees of the company or its subsidiaries (such as in the capacity as a trustee of a pension plan or profit sharing plan).[37] However, securities held by an underwriter for a limited time for the purposes of conducting a bona fide underwriting generally are not considered controlled by the underwriter.[38]
• Options, Warrants, and Convertible Instruments. The Federal Reserve has historically considered a person to control securities that the person (a) has a contractual right to acquire now or in the future or (b) would automatically acquire upon the occurrence of some future event.[39] Consistent with the Proposed Rule and longstanding precedent, under the Final Rule, a person controls a security through the control of an option or warrant to acquire the security or through control of a convertible instrument that may be converted into or exchanged for the security.[40] Certain longstanding exemptions persist in the Final Rule. For example, a person does not control a security by reason of holding an instrument convertible into or exchangeable for the security if the instrument is convertible or exchangeable only in the hands of a transferee after a transfer in a widespread public distribution, in a transfer to the issuer, in a transfer pursuant to which no transferee would receive 2% or more of any class of voting securities of the issuer, or to a transferee that would control 50% or more of every class of voting securities of the issuer without any transfer from the person.[41] Purchase agreements to acquire securities that have not yet closed are also exempted, as are options, warrants, or convertible instruments issued to an investor to maintain his or her percentage of voting securities in the event the issuer increased the number of its outstanding voting securities.[42]

Rebuttable Presumption of Noncontrol

A first company is not deemed to control a second company if none of the control presumptions applies and the first company controls less than 10% of the outstanding securities of each class of voting securities of the second company.[43]

Passivity Commitments

Historically, the Federal Reserve has required minority shareholders to enter into passivity commitments as a condition to obtaining its approval for transactions that present control issues.[44] Going forward, based on the framework contained in the Final Rule, the Federal Reserve does not intend to obtain the standard-form passivity commitments in the ordinary course. However, it will ask for control-related commitments in specific contexts and situations, such as commitments from employee stock ownership plans and mutual fund complexes. With regard to passivity commitments currently in place, companies may contact the Federal Reserve to request relief, and the Federal Reserve expects to be receptive to these requests, absent unusual circumstances.[45]

[1] 12 U.S.C. §§ 1841 et seq. The implementing regulations for the BHC Act are set forth in Regulation Y of the Federal Reserve, 12 C.F.R. Part 225.

[2] 12 U.S.C. §§ 1461 et seq. The implementing regulations for HOLA are set forth in Regulation LL of the Federal Reserve, 12 C.F.R. Part 238. The concept of “control” is substantially the same under the BHC Act and HOLA, and the Final Rule generally takes the same approach with respect to control under both statutes.  Nonetheless, there are statutory differences, including the following: 

• HOLA applies to both individuals and companies that control other companies, while the BHC Act applies only to companies that control other companies. 12 U.S.C. 1467a(a)(2); 12 U.S.C. § 1841(a)(1).
• The BHC Act, unlike HOLA, contains a presumption of noncontrol where a company owns less than 5% voting interest in another company. 12 U.S.C. § 1841(a)(3).

See Preamble at 83 – 84 for a discussion of other differences. In this Client Alert, we largely limit our discussion of the Final Rule as applied to the concept of “control” under the BHC Act and its implementing regulations.

[3] The Final Rule, a chart summarizing the tiered presumptions, a statement by a Federal Reserve Board member, and open board meeting details are available here.

[4] 84 Fed. Reg. 21,634 (May 14, 2019).

[5] Preamble at 86 – 87. As the Final Rule has not yet been published in the Federal Register, citations to the Preamble and Final Rule are to the version published on the Federal Reserve’s website, supra note 3.

[6] 12 U.S.C. § 1817(j).

[7] Preamble at 15.

[8] 12 U.S.C. § 1841(a)(1). Note, pursuant to section 8 of the International Banking Act of 1978, foreign banks with a branch, agency, or commercial lending company subsidiary in the United States are treated as bank holding companies for purposes of the BHC Act. As a result, the concept of control is also essential with regard to the U.S. regulatory framework as applied to foreign banks.

[9] See 12 C.F.R. §§ 225.143; 225.144; 225.138; 225.139.

[10] “First company means the company whose potential control of a second company is the subject of determination by the Board under [Final Rule § 225.31].” Final Rule § 225.31(e)(3). “Second company means the company whose potential control by a first company is the subject of determination by the Board under [Final Rule § 225.31].” Final Rule § 225.31(e)(6).

[11] Preamble at 9.

[12] HOLA and Regulation LL apply to savings and loan holding companies (“SLHCs”). Under HOLA, a company controls another company if, among other things, it has contributed more than 25% of the capital to the other company. The BHC Act contains no such provision. Under the Final Rule, however, the Federal Reserve expects to measure contributed capital under HOLA (and Federal Reserve Regulation LL promulgated thereunder) in the same manner as total equity under the Final Rule, as applicable to bank holding companies under Federal Reserve Regulation Y. Preamble at 84.

[13]Final Rule § 225.31(e)(2).

[14] Final Rule § 225.32(d)(4); (e)(3); (f)(3).

[15] “Senior management officials” includes any person with authority to participate, other than as a director, in major policy-making functions of a company. Final Rule § 225.31(e)(7). The Federal Reserve recognizes that this definition is imprecise and will consider clarifying further after acquiring more experience with the senior management interlocks presumptions. Preamble at 32.

[16] Final Rule § 225.32(b).

[17] 12 CFR § 225.31(d)(2)(i).

[18] Final Rule § 225.31(e)(5).

[19] Final Rule § 225.31(e)(5)(i) and (ii).  See also Preamble at 74 – 80.

[20] Preamble at 78.

[21] Final Rule § 225.32(c); 12 CFR 238.2(e). In the Proposed Rule, the total equity threshold under the BHC Act would have been 25% or more if the first company held 15% or more of the voting equity of the second company. Preamble at 36.

[22] Final Rule § 225.34(c). The Federal Reserve cautions that the list of debt features supporting a reclassification as equity should not be interpreted as indicating that a debt instrument with any one feature would automatically be treated as equity.  Preamble at 72.

[23] Preamble at 73.  See also Final Rule § 225.34(d). 

[24] Preamble at 73.

[25] Final Rule § 225.34(e). Under the Proposed Rule, a first company was required to recalculate its total equity in a second company each time the first company acquired or divested control of equity interests of the second company. Preamble at 71.

[26] Final Rule § 225.32(h).

[27] Final Rule § 225.32(h)(2). This control presumption does not include an exception for investments in SEC‑registered investment companies, subject to certain conditions, that was contained in the Proposed Rule. Preamble at 41 – 43.  

[28] Final Rule § 225.32(g). While this presumption of control applies with respect to consolidation under GAAP, the Federal Reserve will have control concerns where consolidation is under standards similar to GAAP. Preamble at 46.

[29] Final Rule § 225.32(i)(1).

[30] Preamble at 48.

[31] Final Rule § 225.32(i)(2).

[32] Final Rule § 225.32(j).

[33] Preamble at 50.

[34] 12 CFR 225.31(d)(2)(ii).

[35] Preamble at 50.

[36] Preamble at 51; Final Rule § 225.9(c).

[37] Final Rule § 225.2(e)(2).

[38] Preamble at 61.

[39] Preamble at 62.

[40] Final Rule § 225.9(a). In response to the Proposed Rule, some commenters suggested that preferred securities that have no voting rights unless the issuer fails to pay dividends for six or more quarters should be considered voting securities only if the voting rights have been activated. This narrow exception was added to the Final Rule, but other suggested limitations to the look-through approach were not.  Preamble at 64 – 65.

[41] Final Rule § 225.9(a). 

[42] Preamble at 63 – 64; Final Rule § 225.9(a). 

[43] Final Rule § 225.33.

[44] See, e.g., Board of Governors of the Federal Reserve System, Opinion Letter (Nov. 26, 2019), available at https://www.federalreserve.gov/supervisionreg/legalinterpretations/bhcchangeincontrol20191126a.pdf.

[45] Preamble at 85 – 86.