Bracing for Changes in the Bank Control Rules

Executives and directors at public banks need
to prepare for new rules this spring that will make it easier for investors to
accumulate meaningful stakes in their companies.

The Federal Reserve Board has approved an update to the control framework for investors in banks or bank holding companies that goes into effect April 1. The update comes as the marketplace undergoes a structural shift in flows from active fund management to passive investing. The changes should make it easier for investors – both passive and active – to determine whether they have a controlling influence over a bank, and provides both banks and investors with greater flexibility.

“Anything that’s pro-shareholder, a bank
CEO and board should always be happy to support,” says Larry Mazza, CEO at Fairmont,
West Virginia-based MVB Financial, which has $1.9 billion in assets. “The more
shareholders and possible shareholders you can have, it’s very positive for the
owners.”

The Fed last updated control rules in
2008. This update codifies the regulator’s unwritten precedent and legal
interpretations around control issues, which should increase transparency for
investors, says Joseph Silvia, a partner at Howard & Howard.

“The goal of the regulators is to make sure that they understand who owns those entities, who runs those entities and who’s in charge, because those entities are backed by the Federal Deposit Insurance Corp.,” he says. “The regulators take a keen interest, especially the Fed, in who’s running these entities.”

The question of who controls a bank has always been complicated, and much of the Fed’s approach has been “ad hoc,” Silvia says. The latest rule is largely a reflection of the Fed’s current practice and contains few changes or surprises – helpful for banks and their investors that are seeking consistency. Large shareholder should be able to determine if their stakes in a bank constitute control in a faster and more-straightforward way. They also may be able to increase their stakes, in some circumstances. Silvia specifically highlights a “fantastic,” “wildly helpful” grid that breaks down what the regulator sees as various indicia of control, which observers can find in the rule’s appendix.

“A lot of investors don’t like the pain of some of these
regulations – that helps and hurts. [The] regulation creates predictability and
stability,” Mazza says. “Where it hurts is that investors may not go forward
with additional investments, which hurts all shareholders.”

Shareholders, and banks themselves that may want to take stakes in other companies, now have increased flexibility on how much money they can invest and how to structure those investments between voting and non-voting shares, as well as how board representation should figure in. Silvia says this should advance the conversations between legal counsel and investors, and spare the Fed from weighing in on “countless inquires” as to what constitutes control.

“Both banks and shareholders will likely benefit from the
changes, as it could lower the cost of capital for banks while allowing for a
greater presence of independent perspectives in the board room,” wrote Blue
Lion Capital partner and analyst Justin Hughes in an email. Blue Lion invests
in bank stocks.

The change impacts active and passive investors, the latter
of which have grown to be significant holders of bank stocks. Passive vehicles
like exchange-traded and mutual funds have experienced $3 trillion in
cumulative inflows since 2006, while actively managed funds have seen $2.1
trillion in outflows, according to Keefe, Bruyette & Woods CEO Tom Michaud.
Passive ownership of bank stocks has increased 800 basis points since 2013,
representing 17.1% of total shares outstanding in the third quarter of 2019. Some
funds may be able to increase their stakes in banks without needing to declare
control, depending on how the investments are structured.

Still, banks may be concerned about the potential for increased activism in their shares once the rule goes into effect. Silvia says the Fed is familiar with many of the activists in the bank space and will watch investment activity after the rule. They also included language in the final update that encourages investment vehicles who have not been reviewed for indicia of control from the Fed to get in touch, given than no grandfathering was provided to funds that had not been reviewed.

“They’re not really grandfathering any investments,” Silvia says. “There’s not a lot of additional protection.”

If nothing else, the rule is a chance for bank executives and directors to revisit their shareholder base and makeup and learn more about their owners, he adds. They should keep track if the makeup of their shareholders’ stakes changes once the rule goes into effect, especially investors that may become activists.