On April 23, 2019, the Board of Governors of the Federal Reserve System (the "Board") approved a long-awaited proposal (the "Control Proposal" or "Proposal") to revise its rules for determining whether one company has a "controlling influence" over another company for purposes of the US Bank Holding Company Act of 1956, as amended ("BHCA").1 If adopted, the Control Proposal would represent the first material modification to the Board's control regulations since 1984 and would bring significantly more clarity and transparency to an opaque area of the law that has evolved primarily through staff interpretations and opinions delivered in the context of individual transactions—often without being made public or reduced to writing. Comments on the Proposal are due 60 days after its publication in the Federal Register, which is expected to occur shortly.
I. Key Takeaways
As discussed in more detail below, certain aspects of the Control Proposal would formalize, clarify and potentially strengthen what most regard as current Board precedent and policy. Other aspects of the Proposal would break new ground, in certain cases liberalizing and in other cases restricting controlling influence standards as compared to prevailing industry understandings and practice. Before turning to a detailed review of the Control Proposal, we note several significant takeaways and potential considerations for public comment:
- Tiered Framework of Controlling Influence Presumptions. The centerpiece of the Control Proposal is a "tiered framework" of presumptions for evaluating when a particular investment results in a controlling influence and when it does not, based primarily on readily identifiable objective criteria. This represents a significant improvement over the Board's current approach, where the various "indicia of control" are relatively easy to identify but far more difficult to quantify with certainty or reduce to an actionable legal conclusion absent a potentially protracted engagement with Board staff. Provided that the Board in practice adheres to the approach suggested by the Proposal (i.e., effectively precluding the possibility of a control determination where a presumption of controlling influence is not triggered) the Control Proposal should substantially reduce legal uncertainty and the attendant regulatory drag on many kinds of minority investments.
- Reinvigorating the Presumption of Noncontrol for Less than Five Percent Investments. The Control Proposal could breathe new life into the statutory presumption of noncontrol for investments not exceeding five percent of any class of voting securities of another company. While this presumption has long been part of the BHCA, and is already stated in Regulation Y, the Board's highly restrictive approach in recent years on "business relationship" issues in particular—that is, the potential for controlling influence to arise from one company relying on another for a portion of its revenue—had significantly undermined the practical significance of the presumption. Among other things, the Proposal suggests that investments involving less than five percent of a class of the voting securities of another company would not be subject to any "business relationships" test and also would not be susceptible to being viewed as controlling solely on the basis of minority investor veto or consent rights. This represents a potentially significant favorable development for bank holding companies that seek to hold fintech and other portfolio investments under section 4(c)(6) of the BHCA, although the Proposal does not address how these issues should be evaluated for purposes of the "passivity" requirement of section 4(c)(6), which is a distinct but closely related analysis. Comments might seek clarity from the Board on this point.
- Clarifying Statements. The Control Proposal provides greater clarity on a number of particularly nettlesome controlling influence issues, including (i) how to evaluate the impact of creditor's rights arising under a loan facility or other financing arrangement as part of controlling influence analysis; and (ii) how to define and calculate "total equity" within the meaning of the Board's controlling influence framework, including the appropriate characterization of subordinated debt and other equity-like instruments. The Proposal should provide additional comfort to lenders and other providers of financing that they will not be viewed as having a controlling influence over a borrower as a result of contractual restrictions on the borrower's activities, provided that the lender does not also hold five percent or more of any class of the borrower's voting securities.
- Change in Tone. Finally, the Control Proposal reflects a welcome recognition of the statutory framework of the BHCA, including the procedural safeguards established with respect to controlling influence determinations. The Proposal emphasizes throughout that control due to controlling influence can arise only after notice and an opportunity for hearing, and that the tiered presumptions set forth in the Proposal are intended to assist the Board in conducting control hearings. While we do not expect formal control hearings to become the norm, the Board's apparent attempt to anchor the controlling influence framework more closely to its statutory underpinnings (i.e., as compared to some earlier Board policy pronouncements) represents a potentially significant shift in tone and may portend a substantive rebalancing of the approach taken by Board staff with respect to these issues.
While the Control Proposal is on balance, a clear step in the right direction in terms of clarity and transparency, not all of the positions set forth in the Proposal are favorable to the industry.
- Highly Restrictive Revenue Limits for Larger Minority Investments. For investments involving 15 percent to 24.99 percent of a class of a company's voting securities, a proposed revenue test of just two percent (and presumption of control above that level) is highly restrictive—more restrictive in our experience than prevailing industry practice. The revenue test levels for investments involving five percent to 9.99 percent and 10 percent to 14.99 percent of a class of a company's voting securities (i.e., 10 percent and five percent of annual revenues and expenses, respectively) are arguably more consistent with existing Board precedent, although even these restrictions have proven problematic for many investments, particularly in fintech and other startups where revenues can both be highly volatile and often materially diverge from expectations. Further, the Control Proposal is silent regarding how a company should determine when revenue is "generated" by a particular business relationship. Commenters may seek clarity, for example, as to whether this is intended to refer only to direct payments from one company to another or whether more amorphous "referral" or similar types of revenue could be attributed to a particular relationship
- Restrictive Approach to "Limiting Contractual Rights." The Control Proposal would establish a new defined term— "limiting contractual rights"—and a presumption of control for any investor that holds five percent or more of a class of voting securities and any such right. The non-exhaustive list of examples of limiting contractual rights, however, is broad and includes certain "protective" rights of the kind that are often sought by minority investors. Taken together, the highly restrictive approach on business relationships and on limiting contractual rights may suggest an implicit Board policy objective that minority investments, in most cases, should be (i) limited to less than five percent of any class of a company's voting securities and held under section 4(c)(6) or (ii) treated as controlling for BHCA purposes. It is unclear what the industry appetite may be for noncontrolling investments in excess of five percent of a class of voting securities given the significant restrictions that will attach to those investments.
- No Consideration of Other Larger Shareholders in the Tiered Framework. The Control Proposal acknowledges that the Board's controlling influence analysis has historically included consideration of the presence (or not) of other large, countervailing shareholders to mitigate the potential for a particular minority investor to exercise a controlling influence over a target company. However, the proposed tiered framework would not include this factor or assign any particular weight to the existence of other larger (or even majority) shareholders in assessing whether an investor has a controlling influence. The Board suggests that taking account of this factor within the framework could create undue complexity and points out that the Board could rely on its retained discretion to evaluate the impact of other shareholders as part of a "facts and circumstances" analysis. Commenters may want to consider a mechanism for assigning weight to the existence of other large shareholders within the Board's proposed framework, in order to avoid the possible need to revert to the Board's historical transaction-specific approach for analyzing controlling influence in any investment where other large countervailing shareholders are present.
- Registered Investment Companies and Other Investment Funds. The Control Proposal includes several significant provisions related to the treatment of investment funds, including investment companies that are registered with the US Securities and Exchange Commission ("SEC") under the Investment Company Act of 1940 ("RICs"). In particular, the Proposal generally would treat an investment fund, including a RIC, as a controlled subsidiary of a bank holding company ("BHC") (i) if the BHC serves as investment adviser to the fund or RIC and (ii) controls five percent or more of a class of voting securities or 25 percent or more of the total equity of the fund or RIC. The Proposal would provide a seeding period exemption, but only for the first 12 months after formation. This aspect of the Proposal is seemingly out of alignment not only with prevailing industry practice for seeding, but also with other Board regulations and guidance (e.g., under the Volcker Rule) that have recognized a minimum initial seeding period of at least three years. Moreover, many BHCs currently take the view that a RIC for which the BHC provides investment advice is not controlled by the BHC so long as it reduces its seed investment to less than 25 percent of a class of the RIC's voting securities (a position also taken by the Board in the context of the Volcker Rule).
- Look-Through Approach to Convertible Instruments. In an interesting and potentially impactful provision of the Control Proposal, the Board proposes that a holder of options or warrants to acquire voting securities or an instrument convertible into voting securities would be treated as controlling the underlying voting securities "even if there were an unsatisfied condition precedent" to the exercise of the option/warrant or conversion of the instrument. While the Proposal suggests this approach is "consistent with the Board's longstanding precedent," citing the 2008 Policy Statement,2 it in fact arguably goes beyond the 2008 Policy Statement with respect to instruments with contingent exercise or conversion features. Specifically, the 2008 Policy Statement states that "nonvoting shares that may be converted into voting shares at the election of the holder of the shares, or that mandatorily convert after the passage of time, should be considered voting shares at all times" (emphasis added). Because an unsatisfied condition precedent means that a holder does not have the right to elect conversion of the instrument and the instrument by definition does not "mandatorily convert after the passage of time," this aspect of the look-through approach to non-voting instruments appears to exceed some of the Board's prior precedent. Significantly, the Control Proposal does not provide any transition period or otherwise address its potential impact on existing investments and relationships, including those that may have been entered into based on an understanding of the Board's controlling influence precedent that would be altered if the Proposal is adopted. Commenters may seek additional clarity on this point as well.
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