Control : When Loan Covenants Become Limiting Contractual Rights

The Federal Reserve’s 2020 final rule on Control and Divestiture Proceedings brought significant clarity to one of banking law’s most complex areas. Among its most important provisions is the treatment of “limiting contractual rights” — contractual provisions that can, in combination with other factors, create a presumption of control over another company.

What Constitutes a Limiting Contractual Right?

A contractual provision requiring a second company to conform its activities to BHC Act or Home Owners’ Loan Act (HOLA) restrictions is generally classified as a “limiting contractual right.” This classification applies regardless of the type of agreement in which the provision appears. Critically, a loan covenant that meets this definition is a limiting contractual right — the control rule makes no exception for loan agreements.

The Redemption Exception

However, not every protective provision triggers the classification. A provision that gives a company a reasonable and non-punitive mechanism to redeem, reduce, or restructure its investment if the second company fails to conform to activity restrictions is generally NOT a limiting contractual right. The key qualifiers are “reasonable” and “non-punitive” — draconian penalty provisions would likely not qualify for this exception.

The 5% Threshold

Even where a limiting contractual right exists, the presumption of control does not apply if the first company controls less than 5% of any class of voting securities of the second company. This threshold provides a meaningful safe harbor for passive investors with standard protective covenants.

The 2020 amendments to Regulation Y codified these presumptions of control and non-control, replacing the prior case-by-case approach with more predictable regulatory standards.

DM Tip: Banks with equity investments accompanied by loan covenants should evaluate whether those covenants could be classified as limiting contractual rights, especially when combined with voting securities ownership at or above 5%. Consider restructuring problematic covenants as non-punitive redemption rights where possible.

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