FDIC Finalizes Supervisory Regime for Industrial Banks and their Controlling Shareholders

On December 15, 2020, the Federal Deposit Insurance Corporation (“FDIC”) issued a final rule (“Final Rule”) setting forth standards to apply to controlling shareholders of industrial banks that are not subject to consolidated supervision by the Board of Governors of the Federal Reserve System (“Federal Reserve”). The Final Rule is substantially similar to the FDIC’s proposal announced March 17, 2020 (“Proposed Rule”), and will take effect on April 1, 2021.  

The Final Rule is prospective in the sense that it will not apply to an industrial bank that before the effective date is a subsidiary of a company that is not subject to consolidated supervision by the Federal Reserve.

The Final Rule caps a spate of recent developments in the chartering and regulation of industrial banks and the supervision of their shareholders. On March 17, 2020, the same day it announced the Proposed Rule, the FDIC approved applications for deposit insurance submitted by Square, Inc. and Nelnet, Inc., paving the way for the two companies to establish the first de novo industrial banks in over a decade. The approvals followed shortly after the filing with the state of Utah by GreatAmerica Financial Services, a nationwide commercial equipment leasing firm, of an industrial bank charter application on March 4, 2020. Subsequently, the Edward Jones financial advisory firm filed an industrial bank charter application with Utah on July 1, 2020; Rakuten filed an industrial bank charter application with Utah on July 26, 2020; and General Motors filed an industrial bank charter application with Utah on December 11, 2020.

The Final Rule and the recent deposit application approvals signal a path forward for the use of deposit-taking industrial bank charters by companies that cannot (or do not wish to) subject themselves to the activity restrictions of the Bank Holding Company Act of 1956, as amended (the “BHC Act”).

In this Client Alert, we first provide a high-level description of the Final Rule’s key changes from the Proposed Rule. We then provide background on industrial banks. Finally, we provide an in depth discussion of the Final Rule.

Key Changes from the Proposed Rule

The Final Rule varies from the Proposed Rule in a few, limited respects.

• Consumer Data Protection Reporting. As in the Proposed Rule, the Final Rule requires companies that control industrial banks that are not subject to supervision by the Federal Reserve (“Covered Companies”) to submit annual reports to the FDIC that address specified topics, such as those related to their financial condition, and their risk controls and compliance with applicable laws. The Final Rule adds a new topic for Covered Companies to address in their annual reports, namely systems for protecting the security, confidentiality, and integrity of consumer and nonpublic personal information.[1]
• Increased Board Representation for Covered Companies. Under the Final Rule, a Covered Company’s direct and indirect representation on the board of directors of each subsidiary industrial bank must be limited to less than 50% (as opposed to less than 25% in the Proposed Rule). The increased threshold provides additional flexibility to Covered Companies to place their representatives on the board of directors of the subsidiary industrial bank.
• Approval for Board Members and Senior Executives. Under the Final Rule, the addition or replacement of a member of the board of directors (or equivalent) or senior executive officer of an industrial bank during the first three years after becoming a subsidiary of a Covered Company requires prior approval of the FDIC. In the Proposed Rule, the prior approval requirement applied in perpetuity. 
• Approval for Affiliate Officers. Under the Final Rule, prior FDIC approval is required for an industrial bank to employ a senior executive officer who is, or during the past three years has been, associated in any manner with an affiliate of the industrial bank.  Under the Proposed Rule, the restriction applied only to current associates of affiliates of the industrial bank.

Background

The BHC Act is the principal statute that implements the national policy of separating banking from commerce. Under the BHC Act, any company that controls a “bank” must register as a bank holding company and abide by restrictions on the activities in which it and its affiliates can engage.

Among other things, bank holding companies are prohibited from engaging in nonbanking activities—that is, any activities that are not “closely related to” banking or managing or controlling a bank, unless an exemption applies.[2]  In addition, bank holding companies are subject to consolidated supervision by the Federal Reserve. That is, bank holding companies and their nonbank subsidiaries are subject to Federal Reserve examination, supervision, and oversight.

Industrial banks were first organized under state charters in the early 20th century as local consumer finance companies for industrial workers. Their powers vary from state to state. Notwithstanding the general framework created by the BHC Act, industrial banks that are FDIC‑insured depository institutions and function in substantially the same manner as traditional banks are not considered “banks” for purposes of the BHC Act if certain conditions are met. Specifically, an industrial bank will not be considered a “bank” under the BHC Act if it: (1) is chartered in one of five states (Utah, Nevada, California, Minnesota, and Hawaii) and (2) either (a) has less than $100 million in total assets or (b) does not accept demand deposits that may be withdrawn by check.[3] Consequently, any company that controls an industrial bank meeting these conditions is not itself a bank holding company (solely by virtue of that fact) and is not subject to the BHC Act’s nonbanking activity limitations or Federal Reserve consolidated supervision.[4]

As a result, commercial and industrial companies, as a general rule, would not be permitted to control BHC Act “banks” but would be permitted to control industrial banks. In fact, commercial companies, such as BMW, Harley Davidson, and others, controlled industrial banks for years.

Industrial banks have a controversial history, in part because of concerns that industrial banks and their holding companies (a) are at a competitive advantage compared with BHC Act banks and their holding companies and (b) may inject risk into the U.S. financial system by eroding the separation between banking and commerce and avoiding consolidated supervision.  Owing in part to these concerns, the FDIC imposed an administrative moratorium on approving industrial bank applications for deposit insurance in the mid-2000s, which was followed by a legislative moratorium imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The legislative moratorium under the Dodd-Frank Act expired in 2013.

Since 2013, and particularly in the current deregulatory environment, there has been renewed interest in the industrial bank charter, especially from financial technology (“FinTech”) companies that may not be able to comply with the BHC Act’s activity limitations. An industrial bank charter may be attractive to these companies. In particular, through an industrial bank charter, FinTechs can have access to relatively inexpensive, stable funding in the form of FDIC insured time deposits, and can export interest rates across state lines.

Federal Regulation of Companies that Control Industrial Banks

Although exempt from Federal Reserve supervision, parent companies of industrial banks are subject to regulation and oversight by the FDIC.[5] Under the Federal Deposit Insurance Act (“FDI Act”), the FDIC has the authority to examine any affiliate of an industrial bank, including its parent company.[6] In addition, as amended by the Dodd-Frank Act, any company that controls an industrial bank must serve as a source of financial strength for the industrial bank.[7] Authority to regulate controlling companies of industrial banks may also be derived from the FDIC’s responsibility to protect the deposit insurance fund (“DIF”) and ensure the safety and soundness of insured depository institutions.[8]

Before the Dodd-Frank Act amended section 38A of the FDI Act to create a statutory source of strength requirement, the FDIC applied the requirement as a matter of supervisory policy.[9] Historically, to implement the source of strength policy, the FDIC required controlling companies of industrial banks to enter into a capital and liquidity maintenance agreement (“CALMA”). A CALMA generally requires a company that controls an industrial bank to take certain actions to support the capital and liquidity position of the industrial bank in times of financial distress. The FDIC has also exercised oversight over controlling companies of industrial banks through written agreements with controlling parties and conditions imposed in connection with the grant of deposit insurance or issuance of a non-objection to a change in control. Together, these measures had formed the basic supervisory framework in which the FDIC regulated companies that control industrial banks. As explained above, the Dodd-Frank Act turned the source of strength policy into a mandate by explicitly requiring the FDIC to ensure that any company that controls an industrial bank serves as a source of financial strength for the industrial bank.

Overview of the Final Rule

The Final Rule is intended to provide transparency and consistency to the FDIC’s approach to regulating companies that control industrial banks. In addition to codifying current practice, the Final Rule expands requirements in a number of key respects.

Scope of Application

The Final Rule applies to a “Covered Company,” i.e., any company that is not subject to consolidated supervision by the Federal Reserve[10] and that controls an industrial bank (in each case on or after the effective date of the Final Rule) as a result of (i) a change in bank control, (ii) a merger transaction, or (iii) obtaining FDIC deposit insurance through a de novo application or otherwise.  In these circumstances, the FDIC would be in a position to consider whether an industrial bank was controlled by a Covered Company and, if so, what restrictions or commitments the FDIC could require from the Covered Company. Thus, an industrial bank that is not covered by the Final Rule because it was a subsidiary of a company not subject to consolidated supervision by the Federal Reserve before April 1, 2021, could become subject to the Final Rule as a result of a subsequent circumstance listed above.

Choice of Control Definition in the Final Rule

A Covered Company includes only certain companies that “control” an industrial bank. In all material respects, the concept of control for purposes of the Final Rule is the same as the concept of control established under the Change in Bank Control Act (“CBCA”). In other words, “control” is “the power, directly or indirectly, to direct the management or policies of a company or to vote 25% or more of any class of voting securities of a company.”[11] The definition of “control” also includes the CBCA’s rebuttable presumptions of control, pursuant to which a company that holds 10% or more of any class of voting securities of another company is presumed to control the other company if: (1) shares of the other company are registered under section 12 of the Securities Exchange Act of 1934 or (2) no other person owns a greater share of that class of voting securities of the other company.[12] Finally, the definition of “control” includes the CBCA’s rebuttable presumptions of acting in concert.[13]

As a result of the control presumptions taken from the CBCA, there is a disparity between the level of ownership (and other control factors) that would trigger control under the BHC Act and under the Final Rule. For example, under the BHC Act definition of control, there is no presumption of control for shareholders holding 10% or more of any class of voting securities of another company even where the shareholder is the largest shareholder in the company or the company’s securities are registered (absent other indicia of control).[14]

The FDIC addressed this disparity in the preamble to the Final Rule. Determining to retain the definition from the Proposed Rule, the FDIC noted that it is familiar with the definition of control under the CBCA, which it uses in other contexts.  However, the FDIC noted in the preamble to the Final Rule, as it has elsewhere, that “it found the logic of the [Federal Reserve]’s interpretations regarding control under the BHCA useful in analyzing fact patterns under the CBCA, but did not adopt the [Federal Reserve’s] interpretations, preferring instead to review each case based on the facts and circumstances presented.”

Requirements Imposed on Covered Companies

The Final Rule requires Covered Companies to enter into a written agreement (or multiple agreements) with the FDIC and its industrial bank subsidiary as a condition of the FDIC’s non‑objection to a change in control notice, or approval of a merger or deposit insurance application. The agreement(s) must require the Covered Company to do the following:

• List all subsidiaries and update such list annually;
• Consent to examination by the FDIC of the Covered Company and each of its subsidiaries;
• Submit an annual report to the FDIC covering specified topics and any other such reports as requested by the FDIC;
• Maintain such records as the FDIC may deem necessary to assess the risks to the subsidiary industrial bank or to the DIF;
• Cause an annual, independent audit of each subsidiary industrial bank;
• Limit direct or indirect representation of the Covered Company on the board of directors or board of managers of each subsidiary industrial bank to no more than 50%;
• Maintain the capital and liquidity of the subsidiary industrial bank at such levels as the FDIC deems appropriate and take such other actions as the FDIC deems appropriate to provide the subsidiary industrial bank with a resource for additional capital and liquidity; and
• Execute a tax allocation agreement with its subsidiary industrial bank.[15]

In a change from the Proposed Rule, the Final Rule does not provide that the agreement(s) must include additional commitments as required by the FDIC in its sole discretion. This was removed to “avoid confusion that the FDIC would unilaterally impose additional commitments (or restrictions).” However, the FDIC can still impose additional conditions pursuant to its general supervision, examination, and enforcement authorities.

The FDIC anticipates that the written agreements will enable it to have complete and timely information on the activities of a Covered Company and its affiliates. Many of the requirements do not appear to be controversial or overly burdensome because they are already required elsewhere in the law (e.g., for reporting, recordkeeping, or audit purposes) or have historically been required by the FDIC in connection with applications from industrial banks (e.g., the CALMA requirement).

While the requirements are consistent with obligations the FDIC has imposed on existing industrial banks and their controlling shareholders, including with respect to the two de novo approvals from March 2020, there are likely disparities across institutions. With the inclusion of these requirements in the Final Rule, there will be further standardization regarding FDIC’s supervisory approach going forward.

In addition, under the Final Rule, the FDIC reserves the authority to require, in its sole discretion, an individual who is a controlling shareholder of the Covered Company to enter into a written agreement with the commitments described above as a condition for its approval. This is not consistent with the treatment of shareholders that are individuals under the BHC Act, and the Final Rule does not provide any standards or guidance as to when the FDIC would or would not exercise this discretion.

Contingency Plan

Under the Final Rule, the FDIC has the authority to require a Covered Company and its industrial bank subsidiary to submit to the FDIC, and comply with, a contingency plan. The contingency plan would set forth, “at a minimum, recovery actions to address significant financial or operational stress that could threaten the safe and sound operation of the industrial bank and one or more strategies for the orderly disposition of such industrial bank without the need for the appointment of a receiver or conservator.” The contingency plan would be subject to the FDIC’s approval.

A contingency plan would not be a resolution plan (as required by the Dodd-Frank Act), given that it would address the steps an institution would take to mitigate financial and operational stress outside of receivership. However, like a resolution plan, it would facilitate an understanding of the risks and types of events that could create a safety and soundness issue for an industrial bank.

Requirements Imposed on Industrial Banks

Under the Final Rule, the FDIC imposes additional restrictions on industrial banks that are subsidiaries of Covered Companies. Specifically, the Final Rule requires prior approval from the FDIC for such an industrial bank to do any of the following:

• Material changes to the industrial bank’s business plan;
• Addition or replacement of a member of the board of directors (or equivalent) during the first three years after becoming a subsidiary of the Covered Company;
• Addition or replacement of a senior executive officer during the first three years after becoming a subsidiary of the Covered Company;
• Employing a senior executive officer who is, or during the past three years has been, associated in any manner with an affiliate of the industrial bank; or
• Enter into any contract for services material to the operations of the industrial bank with the Covered Company or its subsidiary.

The preamble to the Final Rule provides examples of material changes to an industrial bank’s business plan that would require prior approval of the FDIC. These include:

• Increases in financial statement categories or subcategories (such as types of loans, funding, revenue, or capital) of 25% or more;
• Introduction of distinctly new or different business strategies or objectives, including products or services, target markets, delivery channels, or business development strategies;
• Changes to the institution’s financial strategies, or the acquisition of assets, an operating entity, or the assumption of deposits or other liabilities; or
• Changes in organizational relationships such that the manner in which the institution implements or carries out its business strategies or objectives is impacted.

These restrictions are largely consistent with the FDIC’s current practice with respect to de novo bank applications.  However, what may be different is that historically, conditions imposed on de novo charters generally expire after a three-year period (although it is not uncommon for the conditions to continue if necessary to mitigate risk). Under the Final Rule, there is no time limitation on the conditions imposed on industrial banks, except where indicated above.

Concluding Thoughts

The Final Rule provides greater clarity around the regulatory regime applicable to industrial banks and their shareholders.  Prospective applicants now can better assess the regulatory burden of the industrial bank charter, which should help to inform chartering decisions. 

[1] This topic was added because Covered Companies and their affiliates that are not engaged in financial services may not be subject to the Gramm-Leach-Bliley Act’s consumer privacy provisions (note, industrial bank subsidiaries are subject to such provisions). With this addition to the annual report, the FDIC expects that it will have information sufficient to allow it to monitor potential consumer protection risks.

[2] Certain specially designated bank holding companies that qualify as “financial holding companies” have broader powers, but generally, these are restricted to powers that are deemed financial in nature.

[3] 12 U.S.C. § 1841(c)(2)(H). Industrial banks in operation prior to the enactment of the Competitive Equality Amendments of 1987 are also grandfathered into the exclusion from the definition of “bank.” Id.

[4] Industrial banks remain subject to extensive regulatory requirements and are supervised by both the FDIC and their state chartering authority. Companies that control industrial banks and their affiliates are also subject to the Volcker Rule, i.e., Section 13 of the BHC Act, unless an exclusion or exemption applies.

[5] Parent companies of industrial banks may also be subject to state law requirements, and industrial banks themselves are regulated at both the state and federal levels.

[6] 12 U.S.C. § 1820.

[7] 12 U.S.C. § 1831o-1. The term “source of financial strength” “means the ability of a company that directly or indirectly owns or controls an insured depository institution to provide financial assistance to such insured depository institution in the event of the financial distress of the insured depository institution.” Id.

[8] See 85 Fed. Reg. at 17772 (“A key part of [the FDIC’s] supervision is evaluating and mitigating the risks arising from the activities of the control parties and owners of insured industrial banks to ensure they do not threaten the safe and sound operations of their industrial banks or pose undue risk to the [DIF].”).

[9] Section 4.3 of the FDIC’s Risk Management Manual of Examination Policies (last revised in 2005) explains that commercial companies that control industrial banks may be expected to serve as “a source of strength for their subsidiary bank by providing access to the capital and debt markets, and affording the opportunity to use a variety of technical services not always available to small or mid-size banks.” FDIC, Risk Management Manual of Examination Policies, Section 4.3, available at: https://www.fdic.gov/regulations/safety/manual/.

[10] The definition of Covered Company could create a potentially anomalous result when it comes to foreign banking organizations (“FBOs”) because the definition includes “any company that is not subject to consolidated supervision by the Federal Reserve” and controls an industrial bank. Most if not all FBOs would likely meet this standard even though they may be subject to consolidated supervision by their home country supervisor. The Final Rule does not address this issue. The FDIC did seek comment and consider whether additional requirements should apply to foreign-based Covered Companies.  While not applying additional restrictions to foreign-based Covered Companies, under the Final Rule, the FDIC retains “the flexibility to secure additional commitments from such entities as needed is an effective approach. Such commitments would be in addition to the substantial requirements a Covered Company is subject to in the written agreements with the FDIC required by the final rule, including examination and reporting requirements, capital maintenance of the industrial bank, and contingency planning.”

[11] See 12 C.F.R. § 303.81(c).

[12] See 12 C.F.R. § 303.82(b)(1).

[13] See 12 C.F.R. § 303.82(b)(2).

[14] Recently, the Federal Reserve published a final rule, which establishes and revises certain presumptions used to analyze whether one company controls another company for purposes of the BHC Act and Regulation Y. Our client alert on this final rule is available at https://www.mofo.com/resources/insights/200219-federal-reserve-issues.html.

[15] The tax allocation agreement is designed to assure that tax benefits generated by the industrial back inure to the benefit of the industrial bank, including in the event of the insolvency of the Covered Company or the industrial bank.