February 13, 2020
On January 30, 2020, the Board of Governors of the Federal Reserve System issued a final rule that would update and revise, to some degree, its framework for finding “control” under the Bank Holding Company Act of 1956, as amended (BHC Act).
The new control rule (Control Rule) expands the relationships that an investor can have with a target institution and still be deemed to be non-controlling under the BHC Act. This is relevant both for investments in banking organizations, such as by private equity investors, and for investments by banking organizations, such as in fintech companies.
The Control Rule has the most benefits for investors below 10 percent voting share ownership, as will be described more fully below. In addition to benefiting from broader consent rights and greater business relationships than previously, such investors also have greater power as shareholders to make use of proxy solicitation to challenge management. At the same time, certain aspects of the Control Rule, such as its approach to calculating total equity of a target company, were not expanded from the original proposal and may hinder new investments.
This Client Alert describes the most significant aspects of the Control Rule, which will be effective on April 1, 2020.
The BHC Act defines “control” in the following manner:
The Federal Reserve has not held a control proceeding in decades. Instead, it has developed what may be called a “common law of control,” through individual interpretations and policy statements, in which it has set forth the factors that govern whether a “controlling influence” would exist in particular investments below 25% voting share ownership. It is this “common law of control” that the Control Rule codifies, and, in some cases expands.
Historically, the Federal Reserve presumed that a company did not have control over another company if it owned less than 5 percent of all classes of that company’s voting shares. The Control Rule introduces a new presumption. It states that the Federal Reserve will presume that a First Company does not control a Second Company if it owns 9.99% or less of all classes of the Second Company’s voting shares and no other presumptions of control exist. The presumptions of control differ depending on whether voting share ownership is between 0% and 4.99%, or between 5% and 9.99%.
The Control Rule addresses an inconsistency in the Federal Reserve’s old control interpretations. Under them, a lender with no equity could impose covenants that could substantially restrict the ability of a bank or company to conduct its business without being deemed to control that company. Notwithstanding the presumption of non-control at 4.99% voting shares, an equity investor with de minimis equity ownership could not impose the same restrictions by contract. The Federal Reserve has eliminated this inconsistency, to the benefit of 4.99% or less investors, as described immediately below. Importantly, the Federal Reserve also clarified that the expanded rights for 4.99% or less investors apply both in the case of financial investments as well as nonfinancial investments made under Section 4(c)(6) of the BHC Act.
The Control Rule sets forth differing presumptions of control, depending on the percentage of a class of voting shares in the Second Company that a First Company holds. A summary chart of these presumptions is attached as Appendix 1, and they are as follows (although the Federal Reserve expresses them as presumptions, they act as limitations, so we will describe them in the manner they function):
Control Limitations at 4.99% Voting Share Ownership or Less
Control Limitations at 5% – 9.99% Voting Share Ownership
Control Limitations at 10% – 14.99% Voting Share Ownership
Control Limitations at 15 – 24.99% Voting Shares Ownership
A 4.99% or less voting share investor is able to exercise the greatest amount of influence over a target bank or company. The only limitation on such investors is that they may not have “management agreements” with the Second Company. Such agreements give significant influence over the “general management or overall operations of the Second Company;” the Control Rule gives as an example the rights of a general partner over a partnership or managing member over a limited liability company.
Investors with between 5% and 24.99%, by contrast, are more restricted: they may not have contractual rights that significantly restrict discretion. The Control Rule provides examples of rights that do, and do not, act in this matter.
Rights that significantly restrict discretion include:
Rights that do not significantly restrict discretion include:
The various presumptions in the Control Rule are keyed off percentages of classes of voting shares. The Control Rule largely retains existing practice for calculating these percentages, which is highly conservative: if an investor has options, warrants, or securities that are convertible at its option into voting shares of the Second Company, it controls the maximum number of voting shares that it could hold if it exercised all its options and all similar rights held by other investors are not exercised at all. There are no exceptions for out-of-the-money options. One exception to this general rule is if, by the terms of the instrument, an investor’s rights may be exercised only simultaneously with other investors. Second, and consistent with existing practice, there is an exception for preferred stock and similar instruments that give a holder the right to elect directors if dividends are not paid for a period of time and that otherwise have no voting rights; they are deemed voting securities only when the right to vote arises. A third is a purchase agreement to acquire securities that has not closed. A fourth is for rights to maintain an investor’s current voting share percentage.
In addition, if an investor is subject to an agreement whereby the rights of another holder of voting shares is restricted by the investor, it is deemed to control those shares. The Control Rule provides six exceptions to this rule:
In terms of percentage of votes, the Control Rule states that an investor controls the greater of (i) the number of voting shares it controls divided by the number of issued and outstanding voting shares of that class, and (ii) the number of votes that the investor could cast divided by the number of votes that may be cast under all the issued and outstanding voting shares of that class.
The Control Rule retains the Federal Reserve’s historical limitations on the ability of shares that are initially non-voting to become voting. These limitations are strict, and therefore may affect the attractiveness of holding substantial blocs of non-voting shares notwithstanding the Control Rule’s permitted percentage of total equity of up to one-third.
Non-voting shares may become voting shares in the hands of a transferee only in the following circumstances:
Such shares are also subject to strict transfer limitations.
The Control Rule’s general approach to calculating the percentage of total equity owned by an investor is based on U.S. GAAP, with the Federal Reserve stating that if the Second Company is not a stock corporation or does not prepare U.S. GAAP financial statements, total equity will be calculated “so as to be reasonably consistent” with the U.S. GAAP methodology, “taking into account the legal form of the second company and [its] accounting system.”
Under the general approach, the first step is to determine the percentage of each class of voting and nonvoting common or preferred stock issued by the Second Company that the First Company controls. Pari passu preferred stock is treated as one class of preferred stock. One then multiplies the percentage of each class of stock controlled by the First Company by the value of shareholders’ equity allocated to the class of stock under GAAP, with retained earnings allocated to common stock. The final step is to divide the First Company’s value of shareholders’ equity, as calculated under the previous test, by the total value of the Second Company’s shareholders’ equity, as determined under GAAP. The percentage of total equity is calculated at the time of the First Company’s investment and is required to be recalculated only if and when the First Company acquires additional equity. Although this method of calculating total equity was criticized by commenters with justification, the Federal Reserve was unwilling to depart from the test in the Control Rule, which may hamper certain investments.
There is a special presumption of control for investment funds. A company will be presumed to control an investment fund if it is the fund’s investment adviser and directly or indirectly, or acting through one or more persons, controls 5 percent or more of any class of voting securities of the fund, or controls 25 percent or more of the total equity of the fund. To allow for a seeding period, the presumption does not apply if the investor organized and sponsored the investment fund within the preceding 12 months.
The Control Rule modifies the Federal Reserve’s traditional “tear down” rules under which an investor that had BHC control of a company was required to divest its shares below 10 percent voting share ownership in order to shed control. The Control Rule states that a sale to below 15 percent will divest control once two years have passed. There is an exception if after the divestment, 50 percent or more of each class of voting securities of the divested company is controlled by a person that is not a senior management official or director of the divesting company, or by a company that is not an affiliate of the divesting company.
The Control Rule is a victory for regulatory transparency in that after over 40 years of interpretations, the Federal Reserve has used the notice and comment process to promulgate a regulation on this most important aspect of bank holding company law. Investors – both those who wish to invest in banking organizations, and banking organizations that wish to make non-controlling investments themselves – have gained some incremental benefits, although these are really focused at the level of investments of 9.99% voting shares and below. The framework in the Control Rule, moreover, is just that – a framework. Particular investments will continue to have particular facts that the framework will not clearly answer and for which judgment will be required.
Summary of Tiered Presumptions
(Presumption triggered if any relationship exceeds the amount on the table)
| 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 of the second company | Less than 5% of revenues or expenses of the second company | Less than 2% of revenues or expenses of the second company |
| 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 | BHCs – Less than 1/3 SLHCs – 25% or less | BHCs – Less than 1/3 SLHCs – 25% or less | BHCs – Less than 1/3 SLHCs – 25% or less | BHCs – Less than 1/3 SLHCs – 25% or less |
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[1] In the case of an investment in a savings-and-loan holding company, the relevant total equity percentage is 25% or less in all cases.
[2] In the case of non-GAAP financial statements, the Federal Reserve will rely on the non-GAAP financials, “while taking differences in accounting standards into account as appropriate.”
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions Practice Group, or the following:
Financial Institutions Group:
Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com)
Matthew L. Biben – New York (+1 212-351-6300, mbiben@gibsondunn.com)
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com)
M. Kendall Day – Washington, D.C. (+1 202-955-8220, kday@gibsondunn.com)
Michelle M. Kirschner – London (+44 20 7071 4212, mkirschner@gibsondunn.com)
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)
James O. Springer – New York (+1 202-887-3516, jspringer@gibsondunn.com)
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