Federal Reserve Proposes New Control Regulations
Federal Reserve Proposes New Control Regulations
On April 23, 2019, the Board of Governors of the Federal Reserve System (“Federal Reserve”) released a proposed rule (“Proposed Rule”)[1] to revise regulations related to the determination of “control” under the Bank Holding Company Act (“BHC Act”) and the Home Owners’ Loan Act.[2] The Proposed Rule would “provide substantial additional transparency on the types of relationships that the [Federal Reserve] would view as supporting a determination that one company controls another company” by incorporating existing interpretations under the “controlling influence” prong of the control definition into Federal Reserve regulations and would make certain adjustments to historical Federal Reserve practice in this area. The Proposed Rule would also address other issues that commonly arise when analyzing controlling relationships. Comments on the Proposed Rule will be due 60 days after the date of its publication in the Federal Register.
Background
The concept of “control” is essential for the administration of the BHC Act. This is because the BHC Act applies to “bank holding companies,” which are defined to include any company that has control over a bank.[3] In addition, the restrictions and limitations contained in the BHC Act generally apply to any companies controlled by bank holding companies since the investments and activities of any company controlled by a bank holding company are generally attributed to the bank holding company itself.
For BHC Act purposes, a company is deemed to control another company if:
The first and second prongs of the control definition create two fairly bright-line tests for when one company is deemed to control another company. The third prong of the control definition, however, requires a facts and circumstances analysis.
The BHC Act and current Federal Reserve regulations provide a number of presumptions upon which companies rely to avoid making controlling investments, including a presumption of non-control where a company holds less than 5% of any class of voting securities of another company. The Federal Reserve has also historically provided guidance regarding its controlling influence analysis through the issuance of various policy statements.[4] For example, the Federal Reserve released a policy statement in 2008 that explains that the controlling influence analysis involves a review of certain “indicia of control.” Pursuant to that policy statement, the indicia of control that the Federal Reserve will review to analyze whether a company may exercise a controlling influence over another company includes: total equity held (both voting and non-voting), board representation, business relationships, contractual covenants between the parties, proxy solicitations, and management interlocks, among other things. The Federal Reserve’s controlling influence analysis is also described in various orders it has issued with regard to particular investments or transactions. And, historically, the Federal Reserve has required minority shareholders to enter into “passivity commitments” as a condition to obtaining its approval for certain transactions that present control issues.[5]
Despite the aforementioned presumptions and guidance, companies have found it difficult to discern with certainty when minority investments in other companies could result in a control determination for purposes of the BHC Act. The Proposed Rule is an attempt by the Federal Reserve to consolidate its guidance in this area into a single regulatory framework. In this way, the Federal Reserve seeks to provide greater transparency to investors and bank holding companies as to its approach under the controlling influence prong of the control definition.
Presumptions of Control and Non-Control
If implemented, the Proposed Rule would codify the Federal Reserve’s historical practice and significantly augment the number of presumptions that would apply to potential control situations. [6] The preamble to the Proposed Rule states that the Federal Reserve “generally would not expect to find that a company controls another company where the first company is not presumed to control the second company under the [Proposed Rule].” Nevertheless, the Federal Reserve would retain its authority to determine control based on the specific facts and circumstances presented. In addition, the preamble to the Proposed Rule cautions that a proposed investment can still raise safety and soundness or other concerns that do not meet the expectations or requirements of the Federal Reserve even if the investment does not trigger a presumption of control or otherwise raise controlling influence concerns.
The presumptions in the Proposed Rule can be categorized into three main buckets: (1) presumptions that apply regardless of the voting securities held; (2) presumptions that apply according to the amount of voting securities held (with thresholds set at 5%, 10%, and 15% of any class of voting securities); and (3) presumptions of non-control.[7]
Generally Applicable Presumptions
The Proposed Rule would establish several new presumptions that would apply regardless of the level of investment in the securities of another company. These presumptions include:
Tiered Presumptions Based on Voting Securities
The Federal Reserve structured the tiered presumptions “so that, as an investor’s ownership percentage in the target company increases, the additional relationships and other factors through which the investor could exercise control generally must decrease in order to avoid triggering the application of a presumption of control.” In this regard, the tiered presumptions create three categories, namely, where a company controls: (1) 5% or more but less than 10% of any class of voting securities of another company; (2) 10% or more but less than 15% of any class of voting securities of another company; and (3) 15% or more but less than 25% of any class of voting securities of another company.[8] These tiers are described below and explained in a helpful chart prepared by the Federal Reserve at the same time that the Proposed Rule was released, which is republished at the conclusion of this Client Alert.
5% or more. Under the Proposed Rule, investors controlling 5% or more of any class of voting securities of another company would be presumed to control the other company if at least one of the following factors is also present:
10% or more. In addition to the presumptions described above, investors controlling 10% or more of any class of voting securities of another company would be presumed to control the other company if at least one of the following factors is also present:
15% or more. Finally, in addition to the presumptions described above, investors controlling 15% or more of any class of voting securities of another company would be presumed to control the other company if at least one of the following factors is also present:
Presumption of Non-Control
The Proposed Rule would expand the current presumption of non-control to include any investment of less than 10% of any class of voting securities. The presumption of non-control would apply only if none of the presumptions of control described above are triggered.
Divestiture of Control
Historically, the Federal Reserve has considered a company that controls another company for a significant period of time to retain a controlling influence over that company even after a substantial divestiture. In order to divest control, parent companies have generally been required by the Federal Reserve to reduce their shareholding to below 10% (and in many cases below 5%) of any class of voting securities of the other company and to maintain only minimal business relationships.
The Proposed Rule would continue to treat divestiture situations differently than initial investments. However, the approach to divestiture situations would be relaxed in certain respects. Specifically, under the Proposed Rule, a company that controls another company under the first or second prong of the BHC Act definition of control could divest its interest to 15% or more but less than 25% of any class of voting securities of the other company and would be presumed to control the other company only for the two-year period following the divestiture. After the two-year period, the presumption of control would no longer apply (assuming no other control presumptions are triggered). As described in the preamble, this feature of the Proposed Rule implies that a company may divest control immediately by reducing its investment in any class of voting securities of another company to less than 15% (assuming no other control presumptions are triggered).[9]
Other Issues Addressed in the Proposed Rule
The Proposed Rule addresses a number of other issues that often arise when analyzing control, as briefly summarized below:
Conclusion
The Proposed Rule is a long expected effort by the Federal Reserve to provide greater transparency into its analysis of potential control relationships. While modestly relaxing restrictions, the Proposed Rule would not represent a significant deviation from current Federal Reserve policy. Nevertheless, if adopted as proposed, the Proposed Rule would provide much needed clarity to bank holding companies with respect to their investment activities and to other companies interested in making non-controlling bank investments. The below chart as published by the Federal Reserve is available online.
[1] The Proposed Rule, a chart summarizing the proposed tiered presumptions, and the opening statements of two members of the Federal Reserve Board are available here.
[2] The concept of “control” is largely consistent between the BHC Act and the Home Owners’ Loan Act, with certain distinctions. The Proposed Rule would generally take the same approach with respect to control under both statutes, accounting for those distinctions. In this Client Alert, we limit our discussion of the Proposed Rule as applied to the concept of “control” under the BHC Act and its implementing regulations.
[3] 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.
[4] See 12 C.F.R. §§ 225.143; 225.144; 225.138; 225.139.
[5] Notably, the Proposed Rule does not discuss in what circumstances the Federal Reserve might require a minority shareholder to enter into passivity commitments to avoid control.
[6] Technically, a company may not be deemed to control another company pursuant to the controlling influence prong of the control definition unless the Federal Reserve has determined, after notice and an opportunity for a hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the other company. The presumptions described in the Proposed Rule and in this section would apply for purposes of such proceedings and the presumptions would be rebuttable.
[7] Note, the presumptions of control would not apply with respect to shares held in a fiduciary capacity and certain relationships with registered investment companies.
[8] Investments of less than 5% of any class of voting securities of another company are presumed to be non-controlling investments pursuant to the BHC Act, assuming none of the generally applicable presumptions are triggered. Investments of 25% or more of any class of voting securities of another company are deemed to be controlling investments pursuant to the first prong of the control definition.
[9] To the extent the company’s investment rises above 15% of any class of voting securities of the other company during the two-year period, the company would be presumed to continue to control the other company.
Practices