On April 23, 2019, the Board of Governors of the Federal Reserve System (the “Board”) issued a notice of proposed rulemaking to revise the Board’s rules for determining whether a company has control over another company for purposes of the Bank Holding Company Act (the “BHCA”) and the Home Owners’ Loan Act (“HOLA”). The proposal is intended to clarify and formalize the Board’s current control framework promulgated under Regulation Y and Regulation LL. The proposal promises to not only simplify the Board’s decades-long, ad hoc approach to control evaluations at certain ownership levels, but also to create a comprehensive and transparent set of rules for holding companies and investors. Importantly, the Board has introduced a series of tiered presumptions of control based on a company’s ownership of voting securities. Here are five things you should know about the Board’s proposal.
1. Purpose of the proposal.
Over the years, when evaluating whether a company controls another company, the Board has generally engaged in one of three lines of inquiry:
(i) Does the company own, control, or have the power, directly or indirectly, to vote 25 percent or more of any class of voting securities of the target company?
(ii) Does the company control, in any manner, the election of a majority of the directors of the target company?
(iii) Does the company exercise a controlling influence, directly or indirectly, over the management or policies of the target company?
The first two inquiries are straightforward and supported by bright-line rules and clear precedent. However, the third inquiry has historically involved a fact-based evaluation of each particular case. As a result, the Board’s current control framework is, in part, an organic, piecemeal regime of general standards subject to a variety of factors developed on a case-by-case basis, over several decades. Significantly, these standards have not been codified into Regulation Y or Regulation LL, nor have they been provided to the public in any comprehensive manner. The Board proposes to remedy this problem by providing a complete public statement of its control framework under the BHCA and HOLA.
2. The Board’s proposed tiered control framework.
The Board has proposed a tiered framework incorporating a series of presumptions of control. The presumptions are based on seven factors the Board has typically applied to control determinations, including: (i) the size of the company’s voting equity investment in a target company; (ii) the size of its total equity investment in the target; (iii) the company’s rights to director representation; (iv) the company’s use of proxy solicitations; (v) management interlocks; (vi) covenants or other agreements to control the management or operations of the target company; and (vii) the scope of business relationships between the company and the target company.
The framework works as a matrix – a company may be presumed to be in control based on its ownership of voting securities in a target company. Board staff prepared the following chart to illustrate the tiered control framework
The proposal does not create new rules or tests under the BHCA or HOLA. Instead, the Board has designed the framework to integrate the factors and thresholds that it uses to determine whether a company exercises a controlling influence. Consequently, as an investor’s ownership percentage in a target company increases, the additional relationships and other factors through which the investor may exercise control would need to decrease in order to avoid a presumption of control.
3. Application of the tiered control framework.
The proposal also describes additional provisions to clarify how the tiered framework and presumptions would apply in particular circumstances. Several of these presumptions already exist in Regulation Y and will be retained by the Board with clarification based on public comment and Board staff input. For example, management agreements that raise controlling influence concerns continue to be an important issue. The proposal slightly expands the existing presumption to include other types of agreements and understandings that allow a company to direct or exercise a significant influence over the core business or policy decisions of a company.[5]
Other provisions are new, but derive from uncodified standards the Board has used to make control decisions.[6] For example, a company seeking to divest control has generally been held to a strict standard of reducing its voting ownership level below 10 percent. Under the proposal, that same company would only be required to reduce its ownership to less than 15 percent, or to divest to less than 25 percent and allow two years to pass.[7]
Importantly, the proposal sets forth a new presumption of non-control. As many investors know, a control presumption under the BHCA is currently only avoided if a company owns less than 5 percent of the voting securities of a target company. Under the Board’s proposal, a new presumption of non-control would apply so long as a company holds less than 10 percent of the voting securities of a target company and does not trigger any of the other presumptions of control.[8] The non-control presumption is new in its formulation and issuance, but remains consistent with the current and past practice of the Board.[9]
Nonetheless, consistent with long-standing practice, the Board has reserved its authority to determine that a control relationship exists based on the facts and circumstances of a particular case regardless of these presumptions.
4. Other issues related to the tiered control framework.
The proposal defines several items that are in keeping with the Board’s past and current practice, but that have yet to be codified or the subject of formal public issuances. For example, Regulation Y currently includes a definition of “voting securities” and a separate definition of “nonvoting shares.”[10] Consistent with Board practice, the proposal changes the latter definition to “nonvoting securities” and includes in that definition equity instruments issued by limited liability companies and partnerships.[11] The proposal also addresses standards for determining the number of voting shares that an investor owns under certain circumstances, such as indirect ownership and ownership of options or convertible securities.[12]
5. Significance of the proposal for investors and financial institutions.
The Board’s current control regime is marked by complexity and a lack of transparency. In addition, many of the rules and procedures have remained unwritten or unpublished and, in many cases, have never been subjected to public comment and review. As a result, the system has been characterized by substantial compliance burdens and uncertainty on the part of investors and financial institutions.
The significance of the Board’s proposal is that the tiered framework and presumptions of control (or non-control) will be subjected to public comment, clarified with respect to their application, formalized in a final rulemaking, and then incorporated into Regulation Y and Regulation LL. This should bring increased transparency, predictability, and simplicity to how the Board determines control and give investors a clear understanding of what combinations of investment and influence will, and will not, subject them to Board supervision and regulation.
Community banks and other financial institutions that may need to rely on substantial investments from a few significant investors to raise capital are likely to be affected the most by the Board’s final rulemaking.[13] Likewise, investors in depository institutions and holding companies who seek to avoid control determinations will be impacted.[14] We recommend that all financial institutions and bank investors review and carefully weigh the implications of the Board’s proposal. The Board has incorporated throughout the proposal a series of discrete questions for investors and financial institutions to consider. As with any notice of proposed rulemaking, well-crafted public responses have the potential to inform the Board’s deliberations on the final rule.
Comments on the Board’s proposal are due 60 days following publication in the Federal Register, which is expected to occur in the first part of May 2019.
