Fed’s New Control Rule Brings Transparency, Consistency

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The Federal Reserve Board has announced its much-anticipated final rule that addresses the often-confusing question of when a company controls a bank and when a bank controls another company.

The rule revises existing regulations that address the concept of “controlling influence” for purposes of the Bank Holding Company Act or the Home Owner’s Loan Act. It goes into effect on April 1.

The control rule is important: any entity in control of, or controlled by, a bank is subject to the same regulatory supervision and limitations as the bank. These limitations have created hurdles for bank investments by private equity firms and other entities, and have made partnerships between banks and fintech firms difficult to negotiate and structure.

Under the current Bank Holding Company Act, an investor is deemed to control another company if (1) the investor directly or indirectly owns, controls, or has power to vote 25% or more of any class of a target’s voting securities, (2) the investor controls in any manner the election of a majority of a target’s directors or trustees, or (3) the Federal Reserve determines, after notice and opportunity for a hearing, that the investor directly or indirectly exercises a “controlling influence” over the management or policies of the target.

Under the Bank Holding Company Act, there is a presumption that directly or indirectly owning, controlling, or having the power to vote less than 5% of any class of a target’s voting securities is not considered control. Where a transaction created ownership that exceeded the 5% threshold, it was necessary to address the question of whether there was a controlling influence. Since that term wasn’t defined, parties relied on the Fed’s interpretations in similar situations or sought informal guidance of Fed staff on a case-by-case basis, which led to uncertainty.

“Previously, control reviews have been situation-specific and often followed precedents that were not available to firms or to the public,” the Fed notes in its press release announcing the new rule.

This made business planning difficult, if not impossible. Seeking feedback in the proposal stage often resulted in excessive delays and left the parties with uncertainty as to acceptable structure and permissible relationships going forward.

The new rule seeks to provide more bright-line guidance with a tiered approach to determining  control based on the ownership of voting shares. The indicia of control used for ownership are similar to those applied by the Federal Reserve under the old rule when providing guidance on individual transactions, and vary based on the following levels:

  • less than 5%;
  • 5% to 9.99%;
  • 10% to 14.9%; and
  • 15% to 24.9%.

There are more relationship restrictions as the ownership percentage increases. Those restrictions relate to director representation; officer and employee overlaps; business relationships (including size and terms of relationships); and contractual powers or limitations on operation of the organization. The Federal Reserve outlined the interplay between percentage ownership and restrictions in a chart that was included in the press release. 

Equity investors will have more power to influence a bank’s business, which may spur the influx of capital from new sources. Banks, however, may encounter that influence and the increased rights of investors through proxy solicitations challenging the board. 

From the perspective of banks investing in other companies, the industry had hoped for more relief from the limitations on business and contractual relationships. Large banks have shown interest in investing in fintech startups and limiting their competitor’s ability to participate.

There are other areas the new rule does not address. It does not impact existing investments that have been approved because the parties have agreed with the Fed not to take certain actions (referred to as passivity commitments). The regulator stated it will no longer require or seek those commitments but will consider relieving firms from any existing commitments. 

The new rule also does not impact the concept of control for purposes of other regulations, including the Change in Bank Control Act, Regulation O and Regulation W. So a person or entity will still be required to obtain approval to acquire control of a bank or a bank holding company with the presumption that the acquisition of 10% or more of voting securities being considered a change in control.

There are other aspects of the rule that will need to be considered, including calculating equity ownership, accounting rules and the impact of convertible securities. While the new rule does not provide the level of relief that some in the industry had hoped for, it does provide much-needed guidance that will allow parties to create business relationships with more certainty and efficiency.

Preparing for the New Reality of Bank Activism

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activism-4-8-16.pngFrom 2000 to 2014, activist hedge fund assets under management are reported to have swelled from less than $5 billion to nearly $140 billion. This sharp rise in assets under management is reflected in a 57 percent increase in activist campaign activity over the last five years. And while performance can vary greatly by fund, reports are that activist hedge funds have generally outperformed other alternative investment strategies in recent years. The upshot for the banking industry is clear: as more activist investors with more dry powder are looking for investment opportunities, activists have moved beyond the “low-hanging fruit” into regulated industries, including financial services, which had previously been considered too complex.

Banks historically were viewed as unlikely targets for activist investors. The burdens are significant on an investor deemed to “control” the bank (from a bank regulatory perspective). The investor must be concerned with an intrusive Change in Bank Control Act filing and fundamental changes may be mandated by the Bank Holding Company Act if the investor’s voting, director and activist activities result in it crossing often less than well-defined “control” thresholds. However, today’s activists have learned that even small holdings of a bank’s stock—for example less than 5 percent of voting stock—often suffice to generate the desired change and provide the desired return. Many activists thus have successfully achieved their objectives without triggering bank regulatory consequences.

As activist investors sharpen their focus on the banking sector, their criteria for which entities to target remain the same. Target companies generally share several key characteristics: underperforming (on a relative basis), broadly held ownership structures and/or easily exercisable shareholder rights. An underperforming business presents the potential for economic upside, while a dispersed ownership structure and easily exercisable shareholder rights provide access to the boardroom, or at least the ability to make demands. Activist stakes are often small as a percentage of overall capital and many activist campaigns rely on winning over institutional and other investors on measures to improve the performance of the business and, ultimately, the stock price. These measures can range from those intended to result in a sale of the bank, such as changing directors, to less disruptive, but nonetheless material changes, such as enhancing clawback features in executive compensation plans.

While no two activist campaigns are alike, activist engagement generally begins with a private approach to the board of directors or management. If the activist does not succeed in private conversations, more public disclosure of the activist’s campaign can take the form of public letters to the board of directors or management, public letters to stockholders, white papers laying out the activist proposal, or filings with the Securities and Exchange Commission related to ownership of the target’s stock. Finally, and at greater cost to the activist and target alike, activists can commence a proxy contest or litigation.

So how is a bank to know whether an activist has taken a position in its stock? For smaller, privately held banks, it is more important than ever to maintain close oversight of investor rolls. Publicly traded banks need to monitor Schedule 13D and Form 13F filings. An investor that accumulates beneficial ownership of more than 5 percent of a voting class of a company’s equity securities must file a Schedule 13D within 10 days. In an activist campaign, however, 10 days can represent a very long time and an activist can build up meaningful economic exposure through derivatives without triggering a Schedule 13D filing obligation. 13F filings are made quarterly by institutional investment managers. On the antitrust front, and likely more relevant to midsize and larger banks, an investor that intends to accumulate more than $78.2 million of a company’s equity securities must generally make a Hart-Scott-Rodino (HSR) filing with the Federal Trade Commission and notify the issuer of the securities. As with Schedule 13D filings, an activist can use derivative investments to avoid triggering an HSR filing. Given the limits of these regulatory filings, many publicly traded companies turn to proxy solicitors and other advisors who offer additional data analytics services to track a company’s shareholder base.

Boards must proactively prepare for such events. Any activist response plan will address a handful of key issues, including an assessment of the bank’s vulnerabilities, an analysis of the bank’s shareholder rights profile, engagement with shareholders on strategic priorities generally, identification of the proper team to respond to an activist approach, and ongoing analysis and monitoring of the shareholder base. No plan will address all potential activist approaches, but the planning exercise alone, done well in advance without pressures of an activist campaign, can position a bank to minimize exposure to activist pressures and to respond quickly, proactively and effectively to activist approaches.

Fighting Off the Activists

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3-2-15-CommerceSt.pngShareholder activism is on the rise and has become an increasingly relevant topic in boardrooms throughout the country. The regional and community banking sectors have also seen an increase in activist investors submitting shareholder proposals. The adage is true: The best defense is a good offense. With activist investors, the best defense is maintaining an extremely efficient, profitable bank with performance metrics and key operating ratios in the top quartile of a realistic peer group.  If this does not describe your situation, then your bank may prove an ideal target for an activist. An honest, objective assessment of a bank’s susceptibility to an activist, as well as strategic preparation about the bank board’s initial response will largely dictate the outcome of an activist’s approach. 

Regulatory structures, such as passivity agreements and certain requirements of the Bank Holding Company Act of 1956 (i.e. acting in concert), offer management advantages that are not available to non-banks. However, regulatory impediments generally do not provide much of a deterrent to activists who support their cases with empirical evidence designed to gather the support of other shareholders. More importantly, the playbook for an activist defense too often results in some form of capitulation to an activist. It is not uncommon for an activist to be awarded a board seat or for the target to be forced into announcing a review of its strategic alternatives. While arguably a compromise, too often those concessions are akin to letting the fox in the henhouse and simply put, things are never the same.

Accordingly, even with regulatory protections or other structural impediments that a company may have to slow down an activist, if a board has concerns about its vulnerability to an activist, it would be wise to seek the advice of experienced investment bankers.  Even if the board does not have concerns, it is wise to consult with an investment bank that has not been involved in the business activities of the bank or its holding companies, and is experienced in activism. The investment bankers can provide an independent assessment of the bank along with the available strategies and appropriate tactics to respond to the activist. The investment banker should be prepared to provide underperforming banks with strategic advice on the steps to be taken to increase the profitability of the bank and simultaneously prepare a strategic plan to fend off the unwanted advances of an activist. The plans need to be anticipatory in nature. If the board begins to plan only after an attack, its actions are reactive and the activist is in control of the situation.

When an activist calls, it is often the temptation for management to recommend that the board reject or stonewall the initial foray against the target or as described above, quickly compromise. The circle-the- wagons approach provides the activist just the type of unreasonable response that may garner support for the activist cause.  Failure by management to communicate with the activist shareholder is usually the response that motivates other shareholders to immediately align with the activist. 

Activists do not initiate contact without specific reasoning to put forward valid shareholder proposals. The typical activist is looking for ways to maximize the value of its investment rather than run the bank or remove mangers.The failure to recognize this point causes most targets to act unreasonably and cause the activist to pursue that very strategy of removal. Rather than an out-of-hand rejection, the board should give the activists’ recommendations serious consideration. In some situations, compromise or embracing the viable ideas of an activist may actually have some merit and show that the board is reasonable and confident that it has a plan to address shareholders’ concerns. Whatever the initial reaction by the target, it should not be based on a hasty decision-making process. 

Although it may be wise to give studied consideration to shareholder proposals, this is a far cry from acceptance. In the initial phases of a discussion, the board should consider the ultimate objective of the activist. Is this activist a long-term investor interested in a strategic acquisition? Is he a short-term investor interested in receiving a higher price in the near term? Or, regardless of the investment holding period, is he interested in putting the bank in play in order to precipitate a takeover and obtain a higher price for all shareholders? The ultimate objective of an activist, which can evolve as circumstances change, will often dictate the appropriate corporate response. The board needs to demonstrate it is acting in the best interests of all shareholders and exercising is its fiduciary duties in good faith.