Key Takeaways for Investors from the Fed’s Proposal to Revise its “Control” Regulations

On April 23, the Board of Governors of the Federal Reserve System (FRB) invited public comment on a notice of proposed rulemaking that would revise the FRB’s regulations related to determinations of whether a company (an investor) exercises a “controlling influence” over another company (a target) for purposes of the Bank Holding Company Act (BHCA) or the Home Owners’ Loan Act (HOLA). Whether an investor may exercise a controlling influence over a target is relevant when the investor does not otherwise have control for purposes of the BHCA, such as by owning or controlling 25% or more of a class of the target’s voting securities.

According to the FRB, the proposal would promote a transparent and consistent framework for control determinations, reducing an investor’s risk of unexpectedly acquiring control of a target and the associated regulatory burden. The proposal could benefit banks and fintech companies alike at a time when banks are increasingly considering investments in fintech companies and fintech companies are considering whether to form or acquire depository institution subsidiaries. This additional transparency could also make investments in financial institutions and their holding companies more appealing to investors.

Under the BHCA, which applies to companies, an investor “controls” a target 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 FRB determines, after notice and opportunity for hearing, that the investor directly or indirectly exercises a “controlling influence” over the management or policies of the target. For purposes of the “controlling influence” prong, the BHCA establishes a presumption that an investor that directly or indirectly owns, controls, or has power to vote less than 5% of any class of a target’s voting securities does not control the target. The HOLA’s definition of “control” is very similar to the BHCA’s definition.

A determination of “control” under the BHCA or the HOLA has important consequences. An investor that controls a bank or savings association is regulated as a bank holding company or savings and loan holding company and subject to supervision and examination by the FRB, including the FRB’s significant operational, managerial, and financial requirements. If a target is deemed to be controlled by a bank holding company or savings and loan holding company, the target’s activities may be restricted, and the target may be subject to a variety of other limitations.

Technically, a determination by the FRB of whether an investor exercises a “controlling influence” over a target requires notice and opportunity for a hearing. Such proceedings are rare; rather, investors and targets often seek to structure investments and business relationships to avoid triggering a presumption of control by treating the presumptions in the FRB’s Regulation Y and Regulation LL as “bright line” rules, by evaluating other guidance provided by the FRB, and by consulting with FRB staff.

The proposal would revise Regulation Y and Regulation LL to consolidate and clarify FRB precedent, reflecting the FRB’s historical practices but also effectuating “targeted adjustments.” In the proposal, the FRB stated that it generally would not expect to find that an investor controls a target unless the investor triggers a presumption of control with respect to the target. However, the proposal expressly states that the FRB reserves the right to find that a controlling influence exists based on the facts and circumstances presented by a particular case.

The proposal would create a tiered framework that would incorporate the major factors and thresholds that the FRB often views as presenting controlling influence concerns. Under the tiered framework, as an investor’s ownership percentage in a target increases, the FRB would require other factors through which the investor could exercise control to decrease in order to avoid triggering a presumption of control. An investor’s total voting ownership level (e.g., 5%, 10%, and 15%) forms the backbone of the tiered framework, and these ownership levels would interact with several other key factors to determine whether a controlling influence exists, including the investor’s total nonvoting equity investment; overlapping directors, officers, and employees; contractual arrangements; and the scope of business relationships. To provide investors with more transparency into control determinations, the FRB provided a chart showing how different combinations of ownership levels and key factors would or would not result in a presumption of control. The proposal also includes presumptions of control that are not related to the ownership tiers, as well as an express presumption of noncontrol for investors controlling less than 10% of every class of a target’s voting securities, if the investor does not trigger any other presumption of control factor.

In addition, the proposal relaxes the FRB’s approach to divestitures of control.

Size of Total Equity Investment

The FRB regards the overall amount of an investor’s equity investment in a target (both voting and nonvoting) as a significant indicator of whether the investor controls the target. Under the proposal, the FRB would, consistent with its current practice, continue to presume that an investor controls a target if the investor (1) holds 33.33% or more of the target’s total equity, or (2) owns, controls, or has power to vote 15% or more of any class of the target’s voting securities and 25% or more of the target’s total equity. The proposal also includes provisions addressing the calculation of these thresholds, including the impact of options, warrants, convertible securities, or similar rights.

Director Representation

The proposal relaxes some of the FRB’s historical standards for evaluating whether an investor’s representation on a target’s board of directors confers control over the target. Historically, an investor owning at least 10% of a class of a target’s voting securities could have one director on a target’s board without triggering a presumption of control. However, the FRB permitted an investor to have a second director representative, consistent with the investor’s noncontrolling status, if the second director’s representation on the board was proportional to the investor’s voting interest in the target and there was another large shareholder that controlled the company.

Under the proposal, there is no presumption of control related to board representation with respect to an investor whose investment does not comprise 5% or more of any class of a target’s voting securities. However, as noted above, the ability to select a majority of directors would separately trigger control under the second prong of the statutory definition of control. Under the proposal, an investor owning 5% or more, but less than 25%, of any class of a target’s voting securities would be permitted to have director representation of less than 25% of a target’s board without triggering a presumption of control.

The proposal also treats certain governance rights and board committee participation as indicia of control. The proposal presumes control exists where an investor that controls:

• 5% or more of any class of a target’s voting securities has director representatives who have the power to make or block major operational or policy-making decisions, such as through supermajority voting requirements, veto rights, or similar arrangements.
• 10% or more of any class of a target’s voting securities has directors occupying 25% or more seats on any board committee having the power to bind the target without needing additional action by the full board.
• 15% or more of any class of a target’s voting securities has a director serving as chairman of the board.

Senior Management Interlocks

The proposal presumes control exists where an investor owning 5% or more of any class of a target’s voting securities also has more than one senior management interlock with the target or has an employee or director who serves as the target’s chief executive officer. This presumption is more restrictive than the FRB’s current practice, which does not consider a management interlock with a company in which an investor does not hold 10% or more of any class of a target’s voting securities as presumptively resulting in control and which does not specifically address interlocks involving the chief executive officer. In addition, the proposal presumes control exists where an investor that controls 15% or more of any class of a target’s voting securities has any senior management official interlock with the target. These presumptions focus on senior management officials, rather than “management officials” more generally, with a “senior management official” being any person who participates or has authority to participate in major policy-making functions (other than as a director).

Proxy Solicitations

The proposal presumes control exists where an investor that controls 10% or more of any class of a target’s voting securities also solicits proxies to appoint 25% or more of the target’s directors, but it would not preclude an investor that controls 10% or more of any class of a target’s voting securities from soliciting proxies on other issues.

Contractual Provisions

The proposal presumes control exists where an investor that controls 5% or more of any class of a target’s voting securities also has a contractual right that significantly restricts, or allows the investor to significantly restrict, the target’s discretion over major operational or policy decisions. The FRB has listed nonexhaustive examples of “limiting contractual rights” that would trigger a presumption of control, and those which would not. Notably, the types of contractual restrictions that would trigger a presumption of control are similar to the types of negative covenants that private equity or venture capital investors often seek to obtain.

A presumption of control would be triggered by the following “limiting contractual rights”:

• Restrictions on a target’s business and strategic activities, including (1) entering new business lines, (2) substantially changing or discontinuing existing business lines, (3) entering into contractual arrangements with third parties that impose significant financial obligations on the target, (4) materially altering the target’s policies or procedures, (5) making significant investments or expenditures, or (6) ability to merge or consolidate, or on its ability to acquire, sell, lease, transfer, spin off, recapitalize, liquidate, dissolve, or dispose of subsidiaries or major assets.
• Restrictions on a target’s financing and capital activities, including (1) ability to pay or not pay dividends, change its dividend payment rate on any class of securities, redeem senior instruments, or make voluntary prepayment of indebtedness, (2) ability to authorize or issue additional junior equity or debt securities, or amend the terms of any equity or debt securities issued by the company, (3) ability to engage in a public offering or to list or de-list securities on an exchange, (4) remove or select of any independent accountant, auditor, or investment banker, or (5) ability to significantly alter accounting methods and policies, or its regulatory, tax, or corporate status, such as converting from a stock corporation to a limited liability company.
• Requirements that the target (1) achieve or maintain certain fundamental financial targets, such as a debt-to-equity ratio, a net worth requirement, a liquidity target, or a working capital requirement, or (2) not exceed a specified percentage of classified assets or nonperforming loans.
• Restrictions on the target’s ability to (1) hire, fire, or compensate its senior management officials, or (2) significantly modify employee salary, compensation, employment, or benefits plan policies.
• Restrictions on the target’s ability to amend its articles of incorporation or bylaws, other than limited restrictions that are solely defensive for the investor.

A presumption of control would not be triggered by the following “limiting contractual rights”:

• Restrictions on a target’s ability to issue securities senior to the noncommon stock securities owned by the investor.
• Requirements that the target (1) provide the investor with ordinary financial reports, (2) consult with the investor on a reasonable periodic basis, or (3) notify the investor of material events affecting the target or significant assets.
• Market standard “most-favored nation” clauses.
• Drag-along or tag-along rights, rights of first or last refusal, or stock transfer restrictions related to preservation of tax benefits of a company, such as S-corporation status and tax carryforwards, or other similar rights.
• Requirements that the target (1) maintain its corporate existence, or (2) comply with applicable statutory and regulatory requirements.

Business Relationships

The FRB has historically regarded significant business relationships between an investor and a target as a way for an investor with a significant equity position to exert control over the target. Such relationships have also been viewed as inconsistent with the requirement for an investor to act in a passive manner when making a noncontrolling investment in a target under Section 4(c)(6) of the BHCA. The proposal does not address business relationships with respect to investments that involve less than 5% of any class of a target’s voting securities, but it does create several presumptions of control where significant business relationships accompany larger investments. Specifically, the proposal presumes control exists where an investor controls:

• 5% or more of any class of a target’s voting securities and has business relationships with the target that generate in the aggregate 10% or more of the total annual revenues or expenses of either company.
• 10% or more of any class of a target’s voting securities and has business relationships with the target that (1) generate in the aggregate 5% or more of the total annual revenues or expenses of either company, or (2) are not on market terms.
• 15% or more of any class of a target’s voting securities and has business relationships with the target that generate in the aggregate 2% or more of the total annual revenues or expenses of either company.

Investment Advisers and Investment Companies

The proposal presumes control exists where an investor owning 5% or more of any class of an investment fund’s voting securities or 25% or more of the investment fund’s total equity also serves as the investment fund’s investment adviser. However, this presumption of control would not apply when the investor organized and offered the target investment fund within the prior 12 months (i.e., to provide a one-year seeding period). “Investment adviser” would include certain advisers registered with the Securities and Exchange Commission, Commodity Futures Trading Commission, and their foreign equivalents.

The proposal would also exclude registered investment companies from all presumptions of control, but only if (1) the only business relationships between an investor or other company and the investment company consist of investment advisory, custodian, transfer agent, registrar, administrative, distributor, or securities brokerage services provided to the investment company, (2) the investor or other company does not have representatives that occupy 25% or more of the investment company’s board of directors, and (3) the investor or other company controls less than 5% of each class of the target’s voting securities and less than 25% of the target’s total equity (except during a one-year seeding period).

Divestitures

The proposal would substantially revise the FRB’s existing standards regarding divestiture of control. Under the proposal, an investor that previously controlled a target (e.g., a subsidiary) during the preceding two years would be presumed to continue to control the target if the investor owns 15% or more of any class of the target’s voting securities. As a result, a company generally would not be presumed to control a subsidiary if it divested (1) to below 15%, or (2) to between 15% and 25% and waiting for two years to pass. This presumption of control will not apply if 50% or more of the outstanding securities of each class of the subsidiary being sold is controlled by a single unaffiliated person or company. Other presumptions of control, such as those related to business relationships and interlocks, would continue to apply. The FRB proposal would not presume control upon a company’s threat to dispose of securities of a target, including large-block disposals.

Accounting Consolidation

The proposal presumes control exists where an investor consolidates a target under U.S. generally accepted accounting principles (GAAP). The FRB has also sought public comment on whether a company controls a target if it uses the GAAP equity method of accounting.

Fiduciary Exemption

The proposal’s presumptions of control would not apply to securities held by a company in a fiduciary capacity without sole voting authority.

Public Comments

Public comments about the proposal will be accepted for 60 days after publication in the Federal Register. Interested parties can submit their comments directly to the FRB, but sometimes may prefer to provide input through a trade association or law firm. Our team is ready to help you evaluate the proposal’s impact on your organization, determine whether and how your organization should react, and execute on your chosen approach. For additional information, please contact a member of Goodwin’s Banking group, part of its Financial Industry practice.

About Goodwin:

Goodwin’s financial services practice is one of the most highly regarded and largest financial services practices in the United States. Our clients include most of the largest global banks on Wall Street and throughout the world, including full-service and specialty banks; bank and financial holding companies; credit card, mortgage and other lenders, servicers and insurers; companies offering mutual, hedge and private equity fund products; investment advisers; broker-dealers; institutional investors; and providers of technology and other consumer financial services. We represent many of the most prominent financial institutions worldwide in connection with complex Fintech investments and other strategic initiatives. Our global team has led some of the largest bank consortium deals to date across a wide variety of sub-verticals, including blockchain, trading platforms, technology infrastructure, communications platforms and utilities. Our global multidisciplinary team is cohesively integrated to provide strategic advice and deal execution on behalf of the most impactful participants at the intersection of financial services and technology, from early-stage startup companies (through their entire life cycle) and bulge bracket enterprises.