On April 23, 2019, the Federal Reserve Board (the “Board”) released for public comment proposed changes to its longstanding positions on the exercise of controlling influence under the Bank Holding Company Act of 1956, as amended (the “BHC Act”) (the “Proposal”). The Proposal holds promise for simplification of structures and promoting investment activity in the financial services, asset management and fintech sectors.
The Proposal revises the current approach for determining control and introduces a “Tiered Presumptions” framework that would consider the scope of various relationships at certain thresholds of voting rights (5%, 10% and 15%) to trigger a regulatory presumption of control. Specifically, the Proposal relates to indicia of control that may trigger a presumption of a controlling influence.
While the Proposal is couched in terms of control of a banking organization, it will have farther-reaching effects because the Board uses the same controlling influence standards when analyzing non-banking controlling influence questions. Comments must be received by 60 days after the date of publication in the Federal Register.
1. Control under the BHC Act
Under the BHC Act, control is defined by a three-pronged test: a company controls another company if it (i) directly or indirectly owns, controls, or has the power to vote 25 percent or more of any class of voting securities; (ii) controls in any manner the election of a majority of the directors; or (iii) directly or indirectly exercises a controlling influence over the management or policies.
The first two prongs are bright-line rules favored by investors, who often seek to structure their investments to avoid the responsibilities and restrictions accompanying the statutory definition of control. The third prong—whether a company directly or indirectly exercises a controlling influence over the management or policies of the bank or company (a “controlling influence”)—is a factual determination by the Board.
While investors who own less than 5% of any class of voting securities may rely on a statutory safe harbor to conclude non-control, and investors who own 25% or more of any class of voting securities are presumed to control unless the Board determines otherwise, uncertainty arises when an investor owns between 5% and 25% of any class of voting securities. The BHC Act provides that control due to controlling influence only arises once the Board determines, based on the facts presented and after notice and opportunity for a hearing, that a company controls another company. The lack of a bright-line rule on what constitutes a controlling influence, and the a posteriori nature of a Board determination, has accentuated uncertainty in business planning and contract negotiations and drafting.
2. Proposed Revisions of Existing Presumptions of Control: “Tiered Presumptions” for Finding Controlling Influence
The proposed presumptions are arranged in tiers based on the level of voting ownership of any class—5%; 10%; and 15%. A voting interest exceeding the particular threshold combined with the presence of another specified relationship would trigger a presumption of control.
The Proposal is structured on a sliding scale: generally, as an investor’s ownership percentage of voting shares in a company increases, the additional relationships and other factors through which the investor could exercise control must decrease in order to avoid triggering the application of a presumption of control. The proposed tiered framework is designed to incorporate the major factors and thresholds that the Board has historically viewed as presenting controlling influence concerns. In addition to the ownership percentage of a class of voting shares, the relationships and factors include:
- the size of the total equity investment;
- rights to director and committee representation on the board of directors;
- the use of proxy solicitations;
- management, employee or director interlocks;
- covenants or other agreements that allow for influence or restrict management or operational decisions; and
- the scope of the business relationships.
The Summary of Tiered Presumptions chart accompanying the Proposal’s release includes a shorthand grid showing combinations of voting percentage and relationships that, if exceeded, would trigger a presumption of control under the Proposal:
|Less than 5% voting||5-9.99% voting||10-14.99% voting||15-24.99% voting|
|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||Less than 5% of revenues or expenses||Less than 2% of revenues or expenses|
|Business Terms||N/A||N/A||Market Terms||Market Terms|
|Officer/Employee 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 soliciting proxies to replace more than permitted number of directors||No soliciting proxies to replace more than permitted number of directors|
|Total Equity||Less than one third||Less than one third||Less than one third||
Less than one quarter
Other proposed changes and exclusions to the presumptions of controlling influence:
- Management agreements. Expand the universe of agreements and understandings presumed to constitute control from management agreements (including where the investor is a managing member, trustee or general partner, or exercises a similar function) to any agreement or understanding conveying the ability to direct core business or policy decisions. Routine outsourcing agreements, such as IT services agreements, would not qualify.
- Investment advice. Presumption of control where an investment adviser to an investment fund controls 5% or more of any class of voting securities or 25% or more of the total equity capital subject to an initial 12-month seeding period. Investment fund would be defined to include both investment companies registered under the Investment Company Act of 1940, as amended (the “1940 Act”), and funds exempt from registration under the 1940 Act.
- Divestiture of control. Substantially revise existing standards regarding divestiture of control.
- Registered funds. Limited exception from all of the control presumptions if the second company is a registered investment company and certain other relationships are limited.
- Presumption of non-control. Expand the rebuttable presumption of non-control if none of the proposed presumptions of control is met and the investor owns less than 10% of every class of the voting securities.
3. Stay Tuned
While the Board’s proposal appears to play with the same set of control cards, it represents a significant shuffling of the deck, with potentially significant impact. In particular, the proposal could spur partnerships between banks and fintech companies by helping define non-controlling relationships. In addition, by refining controlling influence standards, the Proposal may encourage investments in bank and bank holding company equity by non-bank investors.