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.

Four Implications of the Fed’s Revised Control Framework

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On April 23, the Federal Reserve released a proposed rule focused on control and divestitures.

The proposed rule revises its regulations concerning when one company has the ability to exercise a controlling influence over another company for purposes of the Bank Holding Company Act (BHCA) and the Home Owners’ Loan Act (HOLA), as implemented by Regulations Y and LL, respectively. While there are countless ramifications for a revised framework on control, based on the specific facts and circumstances of any situation, there are four significant and broad implications for banks and investors.

1. More transparent guideposts on indicia of control. The proposed rule incorporates the most common historical considerations of the Fed when determining whether one company has the ability to exert a controlling influence over a second company for purposes of the BHCA and HOLA. These considerations, or indicia of control, and the rebuttable presumptions outlined in the proposed rule are based on the types and levels of relationships between the companies.

The most important of these considerations has been, and will continue to be, the amount of voting securities owned or controlled by one company in a second company. Indeed, the percentage of voting securities owned or controlled forms the basis of a proposed tiered system to examine the indicia of control. The percentage of voting securities owned or controlled determines the extent to which other relationships between the companies may exist without one company having a controlling influence — at least in the eyes of the Fed.

Significant indicia of control include: the first company’s total equity owned or controlled in the second company; rights to board of directors or committee representation; use of proxy solicitations; common directors, management or employees between the companies; contractual rights that restrict or influence the management or operations of the second company; and the scope of business relationships between the companies.

2. Increased flexibility for banks and investors. The potential transparency on control determinations and indicia of control means more flexibility for banks and potential investors. The outline of the proposed rule provides banks and investors, such as minority equity investors, more flexibility in raising money and structuring investments, especially where there are limited indicia of control otherwise present.

While the proposed rule would not affect potential filings required under the Change in Bank Control Act, the potential clarity and flexibility under the BHCA may offer companies the ability to raise money and close deals quicker and with more limited discussions about control with the Fed.

3. New presumption on noncontrol. The proposed rule contains a new threshold for the Fed’s presumption of noncontrol. Under the BHCA, a company that owns less than 5% of the voting securities of a second company is presumed not to control the second company. The proposed rule would increase the threshold for this presumption of noncontrol to 10%, assuming no other indicia of control are present.

4. New presumption of control related to divestitures. The proposed rule includes a new presumption on divesting control that diverts from the Fed’s historical practice. As banks and investors know, it can be extremely challenging to successfully divest control once the Fed determines you have it.

The analysis traditionally focused on reducing the ownership or control of voting securities to below 10% if not significantly less than that. The proposed rule has added flexibility in proposing that a company may successfully divest control of a second company by reducing its ownership or control of voting securities in that second company to less than 15% — or alternatively, reducing ownership or control of voting securities to between 15 and 25% and waiting for two years without again exceeding the 25% threshold.

These changes are currently in the proposal stage, and the release and effective date of a final rule is uncertain. But it is clear that the Fed is looking to provide significant transparency into its historical practices and consistency, where possible, for future control determinations. The industry would welcome any additional transparency or consistency on control determinations from the Fed.