On January 30, 2020, the Board of Governors of the Federal Reserve System (Federal Reserve) adopted a final rule for Control and Divestiture Proceedings (Final Rule) to clarify the Federal Reserve's considerations when determining whether a company has the ability to exercise "control" or a "controlling influence" under the Bank Holding Company Act of 1956, as amended (BHC Act), and the Home Owners' Loan Act (HOLA). The Final Rule applies both to investments by companies in banking organizations and investments by banking organizations in other companies. The regulations under the Final Rule will be codified in the Board's Regulation Y, 12 CFR Part 225, for bank holding companies, and Regulation LL, 12 CFR Part 238, for savings and loan holding companies.
The Final Rule has an April 1, 2020, effective date and is substantially the same as proposed by the Federal Reserve in May 2019 (Proposed Rule).1 However, the Federal Reserve has adopted a number of key changes in the Final Rule in response to comments received related to requests for additional clarification and re-calibration of thresholds. For a detailed summary of the Proposed Rule, see our previous Advisory.
This Advisory will provide an overview of the Final Rule, with an emphasis on key changes from the Proposed Rule.
- The new control framework reflects the Federal Reserve's desire to shift away from routine consultation with investors regarding presumptions of control to a more rules-based approach. The Federal Reserve anticipates that the Final Rule will provide substantial additional transparency on the types of relationships that are generally viewed as supporting a determination that one company controls another company.
- Under the Final Rule, presumptions of control are generally based on ownership of voting equity and total equity in a company; director representation and ability to elect directors; director and management interlocks; contractual rights to determine management or operational decisions (defined as "limiting contractual rights"); and business relationships. Greater levels of equity ownership by a "first company" in a "second company" (to use the Federal Reserve's new terminology) result in the need for fewer and less significant relationships between the "first company" and the "second company" in other areas to give rise to a rebuttable presumption of control by the "first company."
- The Federal Reserve will not request passivity commitments of the "second company" from investors in the ordinary course of business to establish non-control, but the Federal Reserve will seek such commitments under certain circumstances. Companies that have previously provided the standard form of passivity commitments may contact the Federal Reserve to seek relief from such commitments, and the Federal Reserve expects to be receptive to such requests for relief, absent unusual circumstances.
- The Final Rule is generally less restrictive than the standard forms of passivity commitments formerly required by the Federal Reserve for investments of 10% or more of a class of voting securities of depository institutions and their holding companies. In particular, restrictions on resale by an investor of its shares are not required by the Final Rule, and more business is allowed to be conducted between the investor and investee company.
- The Final Rule includes several anti-evasion provisions targeted at debt arrangements that are the functional equivalent of equity in a company. The Final Rule includes a nonexclusive list of factors that the Federal Reserve will examine in deciding whether to treat debt instruments as equity, and these factors include treatment of the debt as equity under accounting, regulatory or tax standards; subordination of the debt to other debt instruments of the issuing company; qualification as regulatory capital; issuance not on market terms; and extremely long-dated maturity. On the other hand, the Final Rule also provides flexibility for excluding what may nominally be equity instruments from total equity if the equity instruments are functionally equivalent to debt, and includes a non-exclusive list of characteristics that could indicate that an equity instrument may be functionally equivalent to debt (e.g. classification of debt for tax or accounting purposes, limited term, etc.).
- The Final Rule includes certain exclusions and exceptions to the definition of "voting" and "non-voting" securities that are more investor-friendly than the Federal Reserve's prior interpretations.
- The Federal Reserve is not grandfathering nonconforming structures as part of this Final Rule or providing a transition period for conformance. The Federal Reserve will not review existing structures that were previously reviewed by the Federal Reserve unless there are material changes to the structures. For investment structures that were not previously reviewed and cleared by the Federal Reserve as "non-controlling" investments, but that are not in conformance with the Final Rule, the Federal Reserve recommends that related parties contact the Federal Reserve or appropriate Reserve Bank to discuss potential course of actions.
- The Final Rule applies only to "control" determinations under the BHC Act and HOLA, and does not extend to the Change in Bank Control Act, Sections 23A and 23B of the Federal Reserve Act and Regulation W thereunder, or Regulation O.2 However, the Federal Reserve indicated that it may choose to revisit the definition of "control" in these other regulations in the future.
- The total equity threshold to avoid triggering a presumption of control of a company under the BHC Act is set at one-third. For savings and loan holding companies, the total equity threshold is 25% and not one-third, due to differences in the definition of "control" under the BHC Act and HOLA.3
Summary of the Final Rule
The BHC Act and HOLA each provides a three-prong test for determining whether a company controls a bank or savings association. The first two prongs are relatively straight-forward: under each statute, a company controls another company if the first company directly or indirectly or acting through one or more other persons (i) owns, controls or has power to vote 25% or more of any class of voting securities of the second company or (ii) controls in any manner the election of a majority of the directors of the other company. The third prong, however, is based on the facts and circumstances of the investment and a finding or determination by the Federal Reserve that a company directly or indirectly exercises a "controlling influence" over the management or policies of the other company.4
The Federal Reserve has historically interpreted "controlling influence" not to require that an investor actually exercise complete domination or absolute control, but only to require the mere potential for manipulation of the second company.5 This interpretation by the Federal Reserve has led to great uncertainty among investors (including not only investors in banking organizations, but also banking organizations themselves when acting as investors in other companies), and has been the topic of decades of Federal Reserve guidance, nonbinding policy statements, and other public and nonpublic Federal Reserve precedent regarding determinations of "control" and a "controlling influence." 6 The Final Rule provides a comprehensive framework of the various considerations of the Federal Reserve in "control" and "controlling influence" determinations under the BHC Act and HOLA.
The Final Rule includes rebuttable presumptions of control based on a tiered framework focused on equity ownership, business relationships, control over the election of directors, director and senior management interlocks, as well as business terms and contractual arrangements. In addition to the rebuttable presumptions under the tiered framework, the Final Rule includes other rebuttable presumptions of control and non-control focused on prior control relationships, management agreements, investment adviser arrangements, consolidation under generally accepted accounting principles, and equity ownership levels.
The following sections provide further detail on the rebuttable presumptions of control (and non-control) adopted as part of the Final Rule, as well as additional considerations based on commentary in the adopting release for the Final Rule.
Tiered Rebuttable Presumptions of Control (and Non-Control)
Below is a chart summarizing the tiered rebuttable presumptions of control under the Final Rule. The bold language highlights changes from the tiered presumptions introduced in the Proposed Rule. In general, the more equity that a first company owns in a second company, the fewer and less significant the first company's relationships with the second company must be in other areas in order to trigger a rebuttable presumption of control.
|Summary of Tiered
Rebuttable Presumptions of Control
(Presumption triggered if any relationship exceeds the amount in the table)
|Less than 5% voting||5-9.99% voting||10-14.99% voting||15-24.99%|
|Directors||Less than half||Less than a quarter||Less than a quarter||Less than a quarter|
|Director Service as Board Chair||N/A||N/A||N/A||No director representative is chair of the board|
|Director Service on Board Committees||N/A||N/A||A quarter or less of a committee with power to bind the company||A quarter or less of a committee with power to bind the company|
|Business Relationships||N/A||Less than 10% of revenues or expenses of the second company||Less than 5% of revenues or expenses of the second company||Less than 2% of revenues or expenses of the second company|
|Business Terms||N/A||N/A||Market Terms||Market Terms|
|Officer/Management Interlocks||N/A||No more than 1 interlock, never CEO||No more than 1 interlock, never CEO||No interlocks|
|Contractual Powers||No management agreements||No rights that significantly restrict discretion||No rights that significantly restrict discretion||No rights that significantly restrict discretion|
|Proxy Contests (directors)||N/A||N/A||No solicitation of proxies to replace more than permitted number of directors||No solicitation of proxies to replace more than permitted number of directors|
|Total Equity||BHCs-Less than one
SLHCs-25% or less
SLHCs-25% or less
|BHCs-Less than one
SLHCs-25% or less
SLHCs-25% or less
The tiered framework adopted under the Final Rule differs from the Proposed Rule in three notable ways:
- With respect to consideration of business relationships, the Federal Reserve will only take into account the significance of business relationships from the perspective of the investee company, rather than from the perspective of both the investor and investee company; the Federal Reserve recognizes that the significance of business relationships from the perspective of an investor company is not necessarily indicative of the investor's ability to control an investee;
- The rebuttable presumptions of control based on total equity were simplified by establishing a single total equity threshold of one-third or 33% of equity interests under the BHC Act and 25% under HOLA. Under the Proposed Rule, a first company that owned less than 15% of voting securities of a second company would have had to hold less than one-third of the total equity of the second company to avoid control, and if the first company owned more than 15% voting equity, the total equity allowed was reduced to less than 25%; and
- The total equity threshold for triggering a presumption of control under HOLA is 25% (not one-third) due to the differences in the definition of "control" under the BHC Act and HOLA.7
New Control Related Terms Under the Final Rule
In furtherance of clarifying the Federal Reserve's considerations for control determinations, the Federal Reserve also adopted updates and clarifications to its definitions for several control related items as part of the Final Rule.
Among the adopted defined terms are terms that are codified for the first time. The terms "first company" (a company whose potential control of a second company is the subject of determination by the Federal Reserve) and "second company" (the company the control of which by a first company is the subject of a determination of control by the Federal Reserve) were adopted as introduced in the Proposed Rule. Another general term adopted substantially as introduced in the Proposed Rule is "senior management official," defined as "any person who participates or has the authority to participate (other than in the capacity as a director) in major policymaking functions of a company." Other new terms and clarifications that require more detailed discussion are listed below.
Director Representative. The term "director representative" is generally defined as an individual that represents the interests of a first company through service on the board of directors of a second company. The Final Rule includes a non-exclusive list of examples of persons who generally would be considered to be director representatives. The list includes (i) individuals who are officers, employees or directors of the first company that are also officers of the second company; (ii) individuals who were officers, employees or directors of the first company within the preceding two years that are directors of the second company; and (iii) individuals who were nominated or proposed by the first company to be directors of the second company.
Limiting Contractual Right. The term "limiting contractual right" is generally defined as a contractual right that allows a first company to restrict significantly the discretion of a second company, including its senior management officials and directors, over major operational or policy decisions of the second company. The Final Rule includes nonexclusive lists of examples of contractual rights that would be considered "limiting contractual rights" and those that would not be considered "limiting contractual rights."
Control Over Securities and Exceptions to the Look-through Approach. The Federal Reserve has historically treated convertible securities, options and warrants as equity securities owned or controlled by the holder for purposes of control determinations, an approach commonly referred to as the "look-through approach."8 The Final Rule captures this practice under the adopted defined term "control over securities." The new defined term also includes exceptions to the general rule, which are generally based on contractual rights to acquire securities (voting or non-voting) that are exercisable only upon certain triggering events outside of the sole control of the holder, or in the case of preferred securities, that only occur after a delay in performance of contractual obligations governing the preferred securities.
- One is not deemed to have control over voting securities due to controlling a financial instrument that is only convertible, exercisable, or exchangeable after a transfer (i) as part of a widespread public distribution; (ii) to the issuing company; (iii) in which no transferee would receive two percent or more of the outstanding securities of any class of voting securities of the issuing company; or (iv) to a transferee with control of 50% or more of every class of voting securities of the issuing company.
- One that has agreed to acquire securities or other financial instruments pursuant to a securities purchase agreement will not be deemed to have control over such securities or financial instruments until the person actually acquires the securities or financial instruments.
- A right that provides the ability to acquire securities in future issuances or to convert nonvoting securities into voting securities to prevent dilution of one's ownership percentage in connection with future issuances of the company in question does not cause the person to control the securities that may be acquired (however, the right cannot provide the person with the opportunity to acquire a higher percentage of the class of securities than the person controlled immediately prior to the future acquisition).
- Holders of preferred securities that would be a nonvoting security but for a right to vote on directors after six or more quarters of unpaid dividends is not a voting security until the securityholder is entitled to exercise the voting right. This is a new exclusion adopted under the Final Rule that was not included in the Proposed Rule, and an important development. Investors should take note of this exclusion, and the time limit for holding such preferred securities before they are deemed to be "voting securities" for purposes of the BHC Act and HOLA.
Exclusion to Voting Rights for Limited Liability Entities. In general, in order for securities to meet the definition of "nonvoting" under the Federal Reserve's Regulation Y definitions, among other requirements, the securities must not entitle the holder, by statute, charter, or in any manner to select or to vote for the selection of directors, trustees, or partners (or persons exercising similar functions). Under the Final Rule, the Federal Reserve adopted an exception to this rule for limited partnership interests and limited liability company membership interests not otherwise covered as voting securities. Holders of limited partnership interests and limited liability company membership interests may hold "nonvoting securities" that have a right to vote to remove a general partner or managing member for cause, or to approve a replacement general partner or managing member who has been terminated or resigned. The adoption of this exclusion is a welcome change from the Federal Reserve's treatment of these interests in the past.
Other Rebuttable Presumptions of Control (and Non-Control)
Management Agreements. Consistent with the Proposed Rule, the Federal Reserve slightly expanded the existing regulatory presumption of control to expressly identify additional types of agreements or understandings that fall within the presumption, including an agreement where a company is a managing member, trustee, or general partner of another company or exercises similar functions.9
Accounting Consolidation Presumption. Consistent with the Proposed Rule, a first company that consolidates a second company on its financial statements for purposes of US generally accepted accounting principles will be presumed to control the second company.
Control of Investment Fund Presumption. A company that serves as an investment adviser to a fund is presumed to control the fund if the adviser owns five percent or more of any class of voting securities of the fund or 25% or more of the total equity of the fund, with the exception of investment advisers that organize and sponsor the investment fund at issue within the preceding twelve months. The exception allows an investment adviser to avoid triggering this presumption of control over an investment fund that it organizes or sponsors during the initial one-year seeding period of the fund. The Federal Reserve declined to extend the seeding period to three years, despite comments received requesting that the seeding period exclusion be consistent with the seeding period for hedge funds and private equity funds under the Volcker Rule.10 The definition "investment adviser" includes investment advisers registered with the Securities Exchange Commission (SEC), commodity trading advisors registered with the Commodity Futures Trading Commission, foreign equivalents of such investment advisers or commodity trading advisors, and companies engaged in the advisory services listed in 12 CFR 225.28(b)(6)(i)-(iv), which picks up banks, state-registered investment advisers, foreign investment advisers, venture capital fund advisers, and other advisers that are exempt from registration with the SEC. The definition of "investment fund" includes commodity funds, real estate investment trusts, both investment companies registered under the Investment Company Act of 1940 (Investment Company Act) and investment companies that are exempt from registration under the Investment Company Act, and foreign equivalents of either registered investment companies or exempt investment companies.
Presumption of Control for Combined Ownership. A rebuttable presumption of control is triggered when a first company controls at least five percent of any class of voting securities of a second company, and the senior management officials and directors of the first company together with their immediate family members own 25% or more of a class of voting securities of the second company (5-25 presumption).11 The Final Rule includes an exception to this presumption, commonly referred to as the Vickars-Henry exception, for situations where the first company owns less than 15% of each class of voting securities of the second company, and the senior management officials and directors associated with the first company, along with their immediate family members hold or control 50% or more of each class of voting securities of the second company. This exception only applies to the control position of the first company under the BHC Act or HOLA and not the control position of the management officials, directors and their immediate family members.
Breaking Previous Determination of Control by Divestiture. Consistent with the Proposed Rule, a first company that has previously been determined to be in control of a second company may break the presumption of control by (i) divesting to less than 15% of voting interests in the company at issue; or (ii) divesting to less than 25% and waiting two years.
Presumption of Non-Control for Less Than 10% Voting Equity. Consistent with the Proposed Rule, the Final Rule includes a presumption of non-control by a first company that owns less than 10% of every class of voting securities of a second company and does not trigger any of the other presumptions of control. The previous threshold prior to the adoption of the Final Rule was five percent of every class of voting securities of a second company.
Fiduciary Exception to Control. Prior to the adoption of the Final Rule, the rebuttable presumptions of control did not apply to the extent that a first company controlled securities of a second company in a fiduciary capacity without sole discretionary voting authority (i.e., any required votes had to pass through to the beneficiary), although the 1984 adopting release accompanying this clause had excepted non-bank holdings from this requirement.12 In response to comments received arguing that the draft fiduciary exception was overly restrictive in not allowing discretionary voting authority over nonbanking securities, the Federal Reserve amended this exception to more expressly parallel the different fiduciary exceptions in section 3 and section 4 of the BHC Act.13 Under the Final Rule, a first company will not be deemed to be in control of securities of a second company that the first company holds in a fiduciary capacity, except if the second company is a depository institution or a depository institution holding company. A first company that controls securities of a depository institution or depository institution holding company must not have sole discretionary voting authority over the securities, and therefore any required voting rights must be passed through or shared with the beneficiaries of the securities of the second company or the third party trustee.
- The Federal Reserve has stated that investments that do not raise control issues may still raise safety and soundness concerns that would cause the Federal Reserve to place limits or restrictions on the investment. Examples noted include contractual covenants that impair the ability of a banking organization to raise additional capital or that impose financial obligations on the banking organization that are inconsistent with the safe and sound operation of the banking organization, as well as contractual rights that restrict the ability of a banking organization to take appropriate actions to address supervisory issues. Business relationships in general will continue to be an area of review for safety and soundness and other supervisory concerns by the Federal Reserve.
- The 1982 and 2008 policy statements on control and controlling influence previously adopted by the Federal Reserve remain in effect to the extent not superseded by the Final Rule.
- Although the regulations may appear to provide more bright-line standards, the interplay of the percentage of ownership presumptions with the fact-driven presumptions of control (e.g. equity types, management agreements, limiting contractual rights, etc.), as well as the unique facts and circumstances of investment arrangements allow for presumptions of control to be inadvertently triggered. For example, a company may have less than 10% voting equity of a second company, which would result in the company being eligible for the presumption of non-control. However, the ownership of voting equity in addition to the existence of significant business relationships, director representatives, director or management interlocks or contractual relationships could trigger other presumptions of control. The Federal Reserve has reserved the right to make determinations of "control" and "non-control" notwithstanding the rebuttable presumptions of control and non-control adopted under the Final Rule.
- Consistent with the Proposed Rule, the Federal Reserve did not adopt a presumption of control related to proxy contests on issues other than election of directors. The Federal Reserve also did not adopt a presumption of control based on an investor's threats to alter or terminate business relationships or threats to dispose of large blocks of voting or nonvoting securities. The Federal Reserve may, however, consider these actions as relevant to determinations of control considering that these actions may be used as a means to induce a specific action or nonaction by the issuing company, its board, or senior management. The Federal Reserve has required as part of its standard passivity commitments that an investor not engage in these activities. The decision of the Federal Reserve not to adopt presumptions of control for these actions evidences a shift in the view of the significance of these actions and a recognition that an investor should be able to exit investments or business relationships with a company in which it has invested without raising control concerns.
Those seeking advice on the Federal Reserve's rules for determining control under any of the federal banking laws, including the Bank Holding Company Act and the Home Owners' Loan Act, are encouraged to contact any of authors of this Advisory or their usual Arnold & Porter contact.
© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
- Bd. Of Governors of the Fed. Reserve Sys., Notice of Proposed Rulemaking, Control and Divestiture Proceedings, 84 Fed. Reg. 21634 (May 14, 2019).
- 12 U.S.C. § 1817(j); 12 U.S.C. §§ 371c, 371c-1 and 12 CFR Part 223; 12 CFR Part 215.
- 12 U.S.C. §§ 1467a(a)(2)(B) and 1841(a).
- 12 U.S.C. §§ 1467a(a) and 1841(a).
- See, Federal Register Notice (to be published), fn. 20, (citing to Interamericas Investments, Ltd. v. Bd. Of Governors of the Fed. Reserve Sys., 111 F.3d 376, 383 (5th Cir. 1997)).
- Mastery of this precedent, as Federal Reserve Vice Chairman Quarles recently quipped, was to be found "in a small handful of people who have spent a long apprenticeship in the subtle hermeneutics of Federal Reserve lore, receiving the wisdom of their elders through oral tradition in the way that gnostic secrets are transmitted from shaman to novice in the culture of some tribes of the Orinoco."
- 12 U.S.C. §§ 1467a(a)(2)(B) and 1841(a).
- This view was formerly codified in the Federal Reserve's rebuttable presumptions of control for control of voting securities prior to the adoption of the Final Rule. 12 CFR 225.31(d)(1).
- This rebuttable presumption was formerly codified at 12 CFR 225.31(d)(2)(i) prior to the adoption of the Final Rule.
- 12 U.S.C. § 1851(d)(4). The Federal Reserve noted that this presumption does not alter the rules applicable to hedge fund and private equity fund investments under the Volcker Rule.
- This rebuttable presumption was formerly codified at 12 CFR 225.31(d)(2)(ii) prior to the adoption of the Final Rule.
- This exception was formerly codified at 12 CFR 225.31(d)(2)(iv) prior to the adoption of the Final Rule.
- 12 U.S.C. §§ 1842 and 1843.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.