In a highly-anticipated release, the Federal Reserve has issued a final rule amending its regulations governing when one company will be deemed to control another.
The changes will have significant implications for investments by and in banking organizations.1 On balance, it will provide greater certainty and transparency by codifying and clarifying a number of principles for analyzing control that have never before been set out in a comprehensive fashion or in formal regulation. At the same time, the Final Rule and its preamble raise their own questions of interpretation, making it likely that the coming years will see the emergence of a new body of unwritten lore and informal interpretation of the rule. In addition, because the Final Rule is stricter in some respects than the earlier framework, and generally does not adopt a grandfathering concept for existing investments, banking organizations are actively focused on developing approaches to address investments made before the Final Rule's release, as well as "pipeline" investments scheduled to close before the effective date of the Final Rule (April 1, 2020).
The definition of "control" is a foundational concept with far-reaching consequences. It informs when an investor in a banking organization requires Federal Reserve approval and faces the potentially prohibitive regulatory consequences associated with becoming a bank holding company. For bank holding companies and savings and loan holding companies, control defines the perimeter of subsidiaries that will be subject to Federal Reserve supervision and regulation, including activities restrictions applicable to U.S. banking organizations. Perhaps most relevant in the current environment, it affects the permissibility and structure of banking organization investments in non-bank companies, including fintech companies and other financial firms. The definition of control also has implications outside the United States, affecting investments by and in non-U.S. banking organizations.
The Final Rule largely focuses on clarifying when one company would be deemed to exert a "controlling influence" over another under the Bank Holding Company Act. This is often the focus of control determinations, since the other elements of the control definition are bright-line tests involving control of 25% or more of a class of voting securities or control of the election of a majority of a company's board of directors. By contrast, controlling influence is a multi-factor determination, with no statutorily-prescribed formula and based on specific facts and circumstances. Many key elements of control determinations have been based on a patchwork of guidance, precedents and unpublished practices, applied by the Federal Reserve on a case-by-case basis in a manner that has evolved over time. The Final Rule is designed to make the controlling influence determination more predictable and transparent.
The preamble to the Final Rule suggests that it largely codifies existing Federal Reserve precedents and interpretative views. However, it departs from precedent in certain respects, codifies certain views that were not previously consistently applied and also imposes bright-line presumptions of control regarding certain elements of the controlling influence calculus that previously were judged on a facts-and-circumstances basis.
Measured against the control framework that existed previously, the Final Rule makes a number of meaningful improvements. It would make it easier for one company to "de-control" another, and it would provide significantly greater flexibility for minority investors willing to limit their voting interest to under 5% of a class of voting securities (even with non-voting interests as high as 33%). This change will be particularly helpful for banking organizations' minority investments in fintech companies, which often represent a small percentage of voting equity but may involve significant business relationships. It will also simplify investments where an investor seeks certain protective consent rights but is willing to limit its voting interest to under 5%.
On the other hand, measured against the proposal, the Final Rule fell short of expectations in a number of areas where commenters had raised concerns or requests for clarifications. On several topics, the Federal Reserve dismissed in a conclusory way (in some cases without any comment) significant objections to the logic and consequences of the proposal. One important example was the implicit rejection of comments on the proposed total equity calculation and lack of discussion of the potential negative consequences it would have for investments in early-stage fintech companies. After reciting some of the areas addressed by commenters on the proposed methodology, the Federal Reserve's explanation of its reasoning was limited to a statement that: "The Board believes that the GAAP-based core methodology of the Final Rule is effective, fit for purpose, well-understood, and easy to apply." The summary dismissal of thoughtful comments has contributed to some concerns about how the Final Rule may be applied in practice going forward.
In that regard, while investors have generally shared the Federal Reserve's goals of greater certainty and transparency, and the Final Rule advances those goals, a general rule with codified presumptions could also create greater rigidity in how certain controlling influence factors will be assessed. For example, investors above the 5% voting equity threshold will have less flexibility in certain areas than has been the case in practice under the earlier informal framework. This will be especially true if the presumptions are difficult to rebut in practice (as earlier presumptions have been). As a result, control analyses could in practice be less tailored to specific facts and circumstances. The rule also adopts stricter standards than the Federal Reserve's historical approach on certain specific issues, such as re-characterization of certain instruments as equity and a presumption of control based on accounting consolidation.
The most notable aspects of the Final Rule, including changes (or absence of changes) from the proposal include:
— Helpful clarification of the statutory presumption of non-control for investments under 5% voting equity, establishing that business relationships, consent rights, expanded governance representation and management interlocks generally should not trigger control for these investments. In the preamble to the Final Rule the Federal Reserve also confirms what was implicit in the proposal—that compliance with the presumption should be sufficient to permit reliance on Section 4(c)(6) of the Bank Holding Company Act. This is a particularly significant issue given common reliance on Section 4(c)(6) for fintech and other minority investments, including by institutions subject to supervisory limits on expansion or on additional investments.
— Liberalization of the Federal Reserve's approach to evaluating divestitures of control, permitting an investor to retain a voting interest of up to 14.9% (or up to 24.9% with a two-year delay in effect). Shortly before issuing the proposed rule, the Federal Reserve had permitted, in at least one public interpretation, retention of voting interests up to 14.9%. However, divestment down to 9.9% or 4.9% had been required in many earlier cases. This issue is particularly important for spin-offs and similar transactions and may also influence investors' willingness to take initially controlling positions if they know there is a predictable path to divesting control while retaining a significant equity investment.
— A relatively conservative and rigid approach to restricting business relationships for investments of 5% or more of voting equity. The Federal Reserve rejected suggestions that it should move away from its practice of imposing quantitative limits on business relationships and consider more qualitative factors, such as the availability of alternative service providers. Like the proposal, the Final Rule codifies limits on the percentage of revenue and expenses of the investee that such relationships could represent—restricted to as low as 2% for investments over 14.9% voting. The Federal Reserve did modify the rule to specify that the significance of business relationships would be measured only from the perspective of the investee company (not the investor), although in practice few, if any, investments had foundered based on a concern about the materiality of a business relationship to the investor.
— Elimination of the voting percentage cap (14.9%) in the Federal Reserve's 2008 policy statement on equity investments in banks and bank holding companies2 that applied in order for an investor to own more than 25% (i.e., up to 33.3%) of the total equity of a company while avoiding control. In order to take advantage of this additional flexibility to own up to 24.9% of a class of voting securities and 33.3% of the total equity of a company without creating control, the investor would also be required to avoid triggering the other presumptions in the Final Rule.
— Elaboration of the types of protective consent rights and covenants that would, and would not, trigger a presumption of control for investments of 5% or more voting equity or result in an investor being deemed to control securities held by others. As with business relationships, while the clarity the Final Rule provides is helpful, the Final Rule limits investors' flexibility to tailor protections in a manner that addresses their concerns while avoiding consent rights that would create a controlling influence. The end result of the Final Rule will be to limit flexibility to make contextual determinations regarding control rights without engaging with Federal Reserve staff.
— Clarification and liberalization of permitted director and management interlocks, including flexibility for a non-controlling investor to install some senior management officials as well as greater numbers of junior management officials.
— Adoption of a codified approach to calculation of total equity that has the effect of inflating the total equity percentage of preferred equity investors in a company with negative retained earnings, creating significant issues for existing and prospective investments in fintech companies. The total equity calculation will also potentially include subordinated debt instruments and other interests "functionally equivalent to equity," without regard to whether they are held alongside an equity interest.
— Adoption of an approach to calculating voting percentage based on the greater of the percentage of the number of voting shares held or the actual voting power, which will artificially inflate certain investors' percentages above their actual voting power in a high-vote/low-vote share structure.
— Codification of the Federal Reserve's longstanding, conservative look-through approach to calculating voting securities represented by options, warrants and other convertible instruments, which assumes that, when calculating ownership percentages, all such instruments held by the investor are converted (to their maximum potential voting equity holding) and no convertible instruments held by others are converted.
— A new presumption of control for any entity consolidated under U.S. generally accepted accounting principles ("GAAP"). This was one of the more controversial elements of the proposal, given the potential impact on securitizations and other special purpose vehicles, but was adopted as proposed with only limited discussion of the public comments. For foreign banking organizations, the Federal Reserve did clarify that in the absence of an ownership interest in an SPV there would not be a need to transfer a consolidated SPV or non-ownership-interest contractual relationships to a foreign bank's intermediate holding company under Regulation YY.
— With respect to control of advised investment funds, rejection of commenters' suggestion that the requirement to reduce voting equity to 4.9% after the seeding period of an advised fund should be aligned with the 24.9% voting interest permitted under the most recent relevant Federal Reserve precedent. Although the precedent was considered a watershed development at the time, the Federal Reserve dismissed it in adopting the final rule as a "single case."3
— An explicit statement that the Final Rule applies only to Bank Holding Company Act control determinations and not to questions of control under the Change in Bank Control Act ("CIBC Act"), Regulation O and Regulation W, three contexts where the definition of control has significant consequences.
— An apparent rejection of arguments to broadly "grandfather" existing investments that would be presumed controlling as a result of innovations in the Final Rule, although the wording of the preamble suggests that significant room remains for banking organizations to develop thoughtful approaches to consider their portfolios of pre-Final Rule effective date investments.
The Final Rule can be found here. Our memorandum on the proposal can be found here.
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Footnotes
1 Federal Reserve, Final Rule, Control and Divestiture Proceedings (Jan. 30, 2020) (to be codified at 12 C.F.R. Pts. 225 and 238), available at https://www.federalreserve.gov/aboutthefed/boardmeetings/files/control-rule-fr-notice20200130.pdf (the "Final Rule").
2 See Federal Reserve, Policy statement on equity investments in banks and bank holding companies (Sept. 22, 2008), http://www.federalreserve.gov/newsevents/press/bcreg/bcreg 20080922b1.pdf ("2008 Policy Statement").
3 See Federal Reserve Letter re: First Union, dated June 24, 1999.
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