The Federal Reserve Board (FRB) recently issued a proposed rule that would codify and clarify when a company is presumed to have a controlling influence over the management and policies of a second company (Proposed Rule),¹ and therefore be deemed to control such company for purposes of the Bank Holding Company Act (BHCA). The Proposed Rule also applies to determinations of control under the Home Owners’ Loan Act (HOLA) applicable to savings associations and savings and loan holding companies; however, for ease of reference this OnPoint refers only to the BHCA.

The Proposed Rule is the most significant development in the control area in more than a decade. The proposal would impact the extent to which: (i) investors can make non-controlling investments in banks and bank holding companies (banks), and thereby avoid becoming a bank holding company (BHC) itself subject to FRB regulation; and (ii) BHCs can make non-controlling investments in non-bank financial companies.

Comments on the Proposed Rule are due by July 15, 2019.

This OnPoint focuses in particular on the implications of the Proposed Rule for asset managers and other bank investors.

Background

For purposes of the BHCA, a company is deemed to control another company if it:

• Directly or indirectly, or acting through one or more persons, owns, controls or has the power to vote 25% or more of any class of voting securities of the second company (voting control test);
• Controls in any manner the election of a majority of the directors of the second company (board control test); or
• Directly or indirectly exercises, as determined by the FRB after notice and opportunity for hearing, a controlling influence over the management or policies of the second company (controlling influence test).

Unlike the voting control test and the board control test, the controlling influence test is not a bright-line test easily discernible to investors who are attempting to avoid controlling another company. Under the FRB’s control and divestiture procedures, the FRB may issue a preliminary determination of control to a company if any presumption of control set forth in the FRB’s Regulation Y is present, or if it otherwise appears that the company may exercise a controlling influence over the management or policies of the other company.² Historically, the FRB has issued regulations regarding presumptions of control (most recently in 1984) and policy statements (most recently in 2008) that articulate the relevant factors in a controlling influence analysis, including: the size of an investment; the existence of other large shareholders; board representation; restrictive contracts and covenants; and the nature and scope of business relationships between the parties.

The determination that a company has a “controlling influence” over a bank or other company may have significant implications for bank investors – including asset managers and private equity firms – as well as BHCs that invest in non-bank financial companies (e.g., FinTech and digital asset companies). Under the BHCA, a company that controls a bank or BHC becomes a BHC itself and is subject to FRB examinations; reporting obligations; capital and liquidity requirements; source of strength obligations; activities restrictions; and general regulatory and supervisory oversight. Most bank investors are unable or unwilling to become a BHC, and therefore seek to ensure that their investments in banks are non-controlling.

If adopted as proposed, the Proposed Rule would codify a significant portion of the FRB’s historical practices and precedents with respect to controlling influence. However, in some areas, the Proposed Rule would liberalize prior FRB views on control by, for example, permitting significant, non-controlling investors (i.e., those that control between 10 and 24.9% of a bank’s voting stock) to have greater board representation and the ability to conduct proxy contests. In other areas (e.g., with respect to presumptions of control of “investment funds”),³ the Proposed Rule would appear to be more restrictive than the industry might have expected.

The Proposed Rule

The Proposed Rule would provide a series of tiered “presumptions of control,” whereby a company would be presumed to control a bank or other company if certain conditions are met. The presumptions would be based on a company’s level of voting securities in the other company and would include four tiers of voting control: 0-5%; 5-9.99%; 10-14.99%; and 15-24.99%.

The framework would focus on certain relationships between the companies to determine whether the overall relationship provides the acquiring company with the ability to exercise a controlling influence over a bank or other company. In addition to the level of voting control, the tiered framework would consider the following factors, which are generally consistent with the factors historically considered by the FRB when making a controlling influence determination:

• Rights to director representation
• Number of director representatives serving on board committees
• Scope of business relationships
• Officer/employee interlocks between the companies
• Contracts and covenants restricting management’s discretion
• Use of proxy solicitations
• Size of a company’s total equity investment

As a general matter, an investor with a larger percentage of voting securities in another company must have less significant relationships in other areas to avoid a presumption of control over the other company. The following table⁴ summarizes thresholds that, if exceeded, lead to presumptions of control under the Proposed Rule:

In addition to the tiered presumption framework set forth in the above table, the Proposed Rule would include several further presumptions of control, including presumptions that would apply when a company serves as investment adviser to a private investment fund or a registered investment company (registered fund, a category of investment fund). These presumptions, as well as other aspects of the Proposed Rule that may be of particular relevance to asset managers and other bank investors, are discussed below.

Investment Fund Considerations

Under the Proposed Rule, an investment adviser would be presumed to control an investment fund, including a registered fund it manages, if the investment adviser controls: (i) at least 5% of any class of voting shares of the fund; or (ii) at least 25% of the total equity of the fund.⁵ The presumption would not apply if an adviser exceeds those thresholds during a 12-month seeding period with respect to newly organized funds.

This presumption is more restrictive than what many in the industry might have expected based on existing FRB precedents, including statements made by the FRB in connection with adoption of the Volcker Rule. For example, in at least one FRB interpretive letter, an adviser to a newly formed mutual fund was not deemed to control the fund so long as the adviser’s ownership of the fund was reduced to 24.9% or less following the seeding period.⁶ In addition, FRB regulations permit a financial holding company to sponsor, organize and advise a mutual fund so long as the financial holding company reduces its ownership in the fund to below 25% following the seeding period.⁷

The 12-month seeding period in the Proposed Rule also is arguably inconsistent with positions taken by the FRB and the other financial regulators in the context of the Volcker Rule. In that context, the agencies determined that a substantially longer seeding period would be appropriate before a registered fund or foreign public fund would be deemed a banking entity, on the basis of an investment adviser’s ownership interest in the fund. Specifically, under staff guidance, a registered fund or foreign public fund whose investment adviser owns or controls more than 25% of the ownership interests of the fund will not be deemed to be a banking entity during its initial seeding period (typically around three years from the date the investment adviser begins implementing the fund’s investment strategy).⁸ Because the definition of “banking entity” under the Volcker Rule incorporates the control analysis under the BHCA, there would appear to be a strong basis for the FRB to adopt a comparable three-year seeding period in the Proposed Rule for purposes of the proposal’s presumption of control with respect to investment funds.

The proposal solicits comment on all aspects of this presumption, including with respect to the voting security/total equity thresholds and length of the seeding period.

The regulatory implications for investment advisers presumed to control an investment fund may be significant. If a bank-affiliated investment adviser were deemed to control an investment fund, that fund would become a subsidiary of the BHC, and therefore subject to BHCA limitations on activities and investments as well as oversight and supervision by the FRB. However, under the Proposed Rule, it may be difficult in some cases for a bank-affiliated adviser to avoid a presumption of control with respect to an investment fund, particularly in view of the 5% voting interest threshold.⁹

Investment advisers unaffiliated with a bank could also be impacted by the Proposed Rule, under certain circumstances, if the adviser were deemed to control an investment fund that made portfolio investments in bank stocks. The adviser might then need to include those bank stocks when determining the percentage of bank shares it controlled on an aggregate basis, to ensure compliance with applicable regulatory thresholds.

The Proposed Rule provides a limited exemption from the presumptions of control in the Proposed Rule for registered funds. That exemption applies in situations where an investing company (including an investment adviser) controls less than 5% of the voting securities and less than 25% of the total equity of the registered fund, following a 12-month seeding period, provided that: (i) the business relationships between the investing company and the registered fund are limited to investment advisory, custodial, transfer agent, registrar, administrative, distribution and brokerage services; and (ii) director representatives of the investing company comprise 25% or less of the registered fund’s board of directors.

Change in Bank Control Act Considerations

While the Proposed Rule’s new tiered presumptions of control generally would provide investors with greater flexibility to make significant, non-controlling investments in banks for purposes of the BHCA, the potential impact of the Proposed Rule is undercut by the fact that it does not modify the presumption of control for purposes of the Change in Bank Control Act (CBCA). Under the FRB’s regulations implementing the CBCA, an investor is presumed to control a bank if the investor acquires more than 10% of the voting stock of the bank and either: the bank is publicly traded; or the investor would be the largest shareholder of the bank. As a result, despite the fact that the Proposed Rule would permit an investor to acquire up to 24.9% of a bank without being deemed to control the bank for purposes of the BHCA (so long as the investment did not trigger one of the tiered presumptions of control), the investor would still need to obtain prior regulatory approval under the CBCA in order to cross the 10% threshold.

The discrepancy between the presumptions of control under the BHCA and the CBCA would appear to undercut two of the central purposes of the Proposed Rule – to provide greater clarity and certainty for investors as to the meaning of control and enhance the ability of banks to raise capital from investors. While different statutory purposes underpin the BHCA and the CBCA, there would not appear to be any strong policy reason to maintain different presumptions of control with respect to bank investments. This is likely to be an area for comment.

Further, it is worth noting that the Comptroller of the Currency and the FDIC also have adopted regulations implementing the CBCA; which include a 10% presumption of control with respect to banks under their respective jurisdictions. If the FRB were to harmonize its CBCA regulations with the presumptions of control in the Proposed Rule, the other bank regulators presumably would need to consider whether to make similar changes to their regulations.

Passivity Commitments

Historically, investors that acquire 10% or more of the voting stock of a bank have been required by the FRB to provide passivity commitments to evidence their intent not to exercise a controlling influence over the bank. Passivity commitments typically provide (among other things) that an investor will not: (i) have more than a single director representative on the board of the bank; (ii) engage in business transactions with the bank or any of its subsidiaries (subject to certain limited exceptions negotiated on a case-by-case basis); (iii) propose directors in opposition to any nominees of management; (iv) solicit proxies with respect to any matters presented to shareholders; and (v) otherwise exercise or attempt to exercise a controlling influence over the management or policies of the bank.

Specialized passivity commitments also have been provided by a number of large asset managers that have obtained no-action letters from the FRB, which enable them to acquire (through mutual funds and other managed accounts) up to 15% of the voting stock of a bank or BHC without obtaining prior FRB regulatory approval. Those passivity commitments require the asset manager to vote any shares held in excess of 10% on a “mirror” basis with other shareholders, or if mirror voting cannot be implemented, not to vote the shares at all.

The Proposed Rule does not address whether passivity commitments will be utilized by the FRB following adoption of the Proposed Rule, nor does it address whether existing passivity commitments would continue to remain in effect. Arguably, passivity commitments should no longer be necessary as long as an investment does not trigger one of the tiered presumptions of control in the Proposed Rule. This would be consistent with the FRB’s statement in the Proposed Rule’s preamble that, absent unusual circumstances, the FRB would not expect to find that a company controls another company unless the first company triggers a presumption of control with respect to the second company. In addition, investors with existing passivity commitments presumably should be able to petition the FRB to eliminate, or at least modify, the commitments where they are more restrictive (for example, with respect to director representation or business transactions with the bank) than what would be permissible for a non-controlling investor under the Proposed Rule. Clarification as to the use and continued applicability of passivity commitments is another likely area for comment.

Proxy Contests

The Proposed Rule generally would enhance the ability of investors to conduct proxy contests with respect to banking organizations. Historically, minority investors that provided passivity commitments to the FRB (typically investors that controlled 10% or more of the voting stock of a bank but, in some cases, investors that controlled 5% or more of the voting stock) were prohibited from soliciting proxies with respect to any matters presented to shareholders, including the election of directors. However, under the Proposed Rule, a presumption of control would be triggered only if a 10% or greater shareholder solicited proxies to elect directors representing at least 25% of the board. This would align the presumption of control regarding proxy solicitations with the number of directors an investor could have on the board under the proposed tiered thresholds. Therefore, a 10% or greater shareholder could solicit proxies to elect directors in opposition to management without triggering a presumption of control, so long as the number of directors proposed to be elected, together with any existing director representatives of the investor, would not comprise more than 24.9% of the board.

The Proposed Rule does not include a presumption of control with respect to proxy solicitations to elect directors by holders of less than 10% of the voting stock. At that ownership level, presumably a shareholder could solicit proxies to elect directors comprising less than a majority of the board. However, as with 10% or greater shareholders, shareholders with ownership interests at the 5-9.9% level are presumed to control a bank under a separate presumption if they have director representatives comprising 25% or more of the board. Since “director representative” is defined to include directors of the bank that have been nominated or proposed by the investing company, arguably this would mean that 5-9.9% shareholders would be subject to the same 24.9% board composition limit as 10% or greater shareholders when soliciting proxies to elect directors in opposition to management’s nominees. While this does not appear to be the intent of the FRB, as the Proposed Rule distinguishes between shareholders above and below the 10% voting threshold for purposes of the proxy solicitation presumption, investors may wish to seek clarification on this point during the comment process.

The Proposed Rule does not impose any limits on the solicitation of proxies with respect to issues other than the election of directors. As noted by the FRB in the Proposed Rule’s preamble, to do so would provide non-controlling investors with greater latitude to exercise their shareholder rights and engage with a target banking organization and other shareholders on certain matters. This represents a significant liberalization of the FRB’s past practice and precedents in this area.

Footnotes

1) See Control and Divestiture Proceedings, Notice of proposed rulemaking with request for comment, 84 Fed. Reg. 21634 (May 14, 2019) (Proposing Release).

2) See 12 C.F.R. § 225.31(a)(1)

3) The Proposed Rule defines “investment funds” broadly to capture a “wide range of investment vehicles,” including investment companies that are either registered or exempt from registration under the 1940 Act, their foreign equivalents, commodity pools and real estate investment trusts.

4) See Memo from FRB Staff, Notice of Proposed Rulemaking to Revise FRB Rules for Determining Whether a Company has Control Over Another Company (Apr. 16. 2019), Appendix A.

5) For purposes of the Proposed Rule, an “investment adviser” would include investment advisers and commodity trading advisors registered as such with the SEC under the Investment Advisers Act of 1940 or with the CFTC under the Commodity Exchange Act, respectively, or any entity that is a “foreign equivalent” of such investment adviser or commodity trading advisor.

6) See, e.g., Letter to H. Rodgin Cohen, dated June 24, 1999, available at https://www.federalreserve.gov/boarddocs/legalint/BHC_ChangeInControl/1999/19990624/#f1.

7) 12 CFR 225.86(b)(3).

8) See Volcker FAQ #16, available at https://www.federalreserve.gov/supervisionreg/faq.htm#16. FAQ #16 permits investment advisers to own more than 25% of the registered fund or foreign public fund without the fund being deemed a banking entity (and therefore subject to the Volcker Rule), in order to permit the fund to establish a track record and gain outside investors so long as the registered fund or foreign public fund is not being used to evade the Volcker Rule.

9) For example, in securitization transactions, under risk-retention rules that may be applicable, the sponsor of the transaction (or another entity permitted to hold a risk-retention interest) is required to retain “skin in the game” by holding securities issued in the securitization transaction for most or all of the life of the transaction. This risk-retention interest varies somewhat, depending on whether the sponsor is complying with one or more of the U.S., EU or Japanese risk-retention rules. In the United States, the rules require the sponsor to hold either: (i) a 5% vertical strip of each tranche of the securities issued by the issuer; or (ii) 5% of the fair market value of all securities in the issuing entity issued as part of the securitization transaction. Therefore, depending on the risk-retention interest acquired and whether the interest would be viewed as a voting security, as the Proposed Rule is currently drafted, a bank-affiliated adviser sponsoring a securitization transaction could be deemed to control the securitization vehicle for BHCA purposes as a result of the proposed presumption of control with respect to investment funds.