The Board of Governors of the Federal Reserve System (the Board) issued a much-anticipated final rule (Final Rule) on January 30 to amend and codify—in certain respects, for the first time—its framework for making “controlling influence” determinations under the Bank Holding Company Act of 1956, as amended (BHCA), and the Home Owners Loan Act (HOLA). The Final Rule will have a significant impact on the viability, structure, and terms of minority investments in and by a broad range of financial services market participants, including banks and bank holding companies (BHCs), savings associations and savings and loan holding companies (SLHCs), and foreign banking organizations (FBOs), as well as hedge funds, private equity firms, and other investors in any of the aforementioned banking organizations.[1] The Final Rule also will be of critical significance for fintech companies, other nonbank financial services firms, and any other company in which a banking group may acquire a minority investment.
Consistent with the objectives articulated in the April 2019 notice of proposed rulemaking to amend the control framework (the Proposal), the Final Rule makes substantial progress in establishing a more transparent and predictable framework for determining whether a particular equity investment, coupled with other factors, will constitute a “control” relationship for US regulatory purposes. As was the case under the Proposal—see our prior discussion of the Proposal—the centerpiece of the Final Rule is a matrix of “tiered presumptions” of control that identifies, based primarily on readily identifiable objective criteria, those relationships that will be presumed to give rise to a controlling influence over an investee company. Investments and relationships not giving rise to a presumption of control under the Board’s matrix generally should qualify as non-controlling. The Final Rule also includes a number of important presumptions outside the tiered framework, including special rules related to control over investment funds for which a BHC or an affiliate serves as investment adviser, control based on accounting consolidation under US generally accepted accounting principles (US GAAP), and revisions to the rules and presumptions governing divestitures of control.
The Final Rule makes welcome progress in bringing greater transparency and predictability to an area of US financial regulation that has long challenged industry participants and practitioners alike. As noted by the Board’s Vice Chair for Supervision, Randal Quarles, the Board’s controlling influence precedent has developed over decades of transaction-specific decisions by Board staff, in many cases with little or no public record, and without many of the Board’s standards having been subject to notice-and-comment rulemaking. For many minority investments in and by BHCs, this historical approach has resulted in legal uncertainty, heightened execution risk, and increased time and costs for many types of transactions.
At the same time, the codification in the Final Rule of specific quantitative and qualitative thresholds for each individual control factor—i.e., in lieu of a holistic “facts and circumstances” approach—means that some investments that might reasonably have been characterized previously by regulated firms as non-controlling will require reassessment in light of the new bright-line standards.
In terms of substantive control thresholds, the Final Rule reflects only incremental changes and some slight recalibration as compared to the Proposal. The Board largely rejected industry comments urging more transformational changes, including confining controlling influence determinations to relationships involving actual, operational control; relaxing the Board’s controlling influence standards as applied to home country and/or extraterritorial investments by FBOs made in accordance with home country law; and permitting substantially larger business relationships with non-controlled firms (including fintechs and other startups). The Board also rejected industry calls to recognize the existence of larger (including majority) shareholders under its tiered framework, as well as calls for phase-in periods and grandfathering arrangements to protect or at least allow time for canvassing and conformance of investments entered into before the issuance of the Final Rule.
Ultimately, the Board has maintained the view that the Proposal was primarily an articulation of existing standards and, in the Final Rule, did not seek to fundamentally alter those standards. However, there are important nuances to the Final Rule—presenting both risks and opportunities—that industry participants of all kinds will need to study. Our analysis of key aspects of the Final Rule and their potential business impact are set forth below.
A. Tiered Presumptions of Control
As noted above, the Final Rule generally retains the matrix of tiered presumptions of control that were included in the Proposal, with just minor “targeted adjustments.” The presumptions are based, first, on the amount of voting securities that one company holds in another, and then on whether some other specified relationship exists in combination with the voting interest. As under the Proposal, the key thresholds for voting securities are 5%, 10%, and 15%, with the most stringent restrictions on other control factors applying at the high end of the spectrum. Those additional control factors continue to include (i) the number of director representatives attributable to a minority investor; (ii) whether one or more director representatives serve as board chair or on certain key committees; (iii) the existence of significant business relationships between the investor and investee companies; (iv) the terms of such business relationships (i.e., market v. non-market); (v) the existence of officer or employee interlocks; (vi) the existence of certain contractual rights with respect to the investee company; (vii) proxy solicitations; and (viii) the amount of total equity the investor company holds (including non-voting equity). The Board’s graphic summarizing these presumptions is available here.
Under the Final Rule, the Board retains discretion to make a control determination based on the particular facts and circumstances of a given relationship. The Board, however, has stated in the Final Rule that it “generally does not expect to find that a company controls another company unless the first company triggers a regulatory presumption of control with respect to the second company.” While this Board stance does not provide absolute certainty that a given relationship between an investing and investee company will never be treated as a control relationship if one of the regulatory presumptions of control is not triggered, in practice the Board’s position should encourage minority investors to take more confident positions with respect to their investments in, and relationships with, investee companies without undue concerns over triggering a BHCA control relationship.
B. Business Relationships
A key issue for many industry participants in the lead up to the Proposal and during the comment period was the extent to which a small equity stake in a company, coupled with a “significant business relationship” between the companies, could give rise to a control relationship. This concern arises frequently in the context of BHC investments in fintech and other startup companies, where the BHC investor might seek some equity upside on a particular startup technology where the BHC is a significant (or in some cases the sole) customer of the technology. Industry representatives pushed for significant relaxation of the business relationships tests included in the Proposal, both with respect to the general thresholds at which a presumption of control would be triggered and specifically with respect to how the rules would apply to startup ventures. The Board elected not to provide any such relief, maintaining caps ranging from just 2% of annual revenue or expenses of an investee company (where the investor holds 15% or more of voting shares) up to 10% of annual revenues or expenses (where the investor holds 5% to 9.9% of voting shares).[2]
Significantly, the Final Rule indicates that there generally will be no possibility of a presumption of control based on business relationships where an investor holds less than 5% of a class of voting shares of an investee company (see the discussion of the 5% safe harbor below). The Final Rule provides that any agreement or understanding between an investor and investee company whereby the former “directs or exercises significant influence or discretion over the general management, overall operations, or core business” of the latter creates a controlling influence presumption regardless of the percentage of shares held by the investor company. It does not, however, so state for business relationships between the investing and investee company that do not involve this type of “management agreement” relationship. That said, these control and non-control provisions are presumptions only, and they would not prevent the Board—presumably only in unusual circumstances—from determining the presence of control based on business relationships, even with shareholdings of under 5%.
C. Limiting Contractual Rights
The Final Rule retains the same approach to contractual covenants and veto rights as was included in the Proposal. Specifically, any investor that holds 5% or more of a class of voting shares of a company will be presumed to control the company if it has even a single “limiting contractual right.” This includes situations where the contractual right at issue arises out of a separate credit facility or other financing arrangement between the investor (or an affiliate) and the investee company and is in the nature of a market-standard creditor protection. Market participants seeking to avoid control therefore will need to carefully evaluate relationships involving a combination of debt and equity financing to ensure they avoid taking on rights in the context of the debt arrangement that would result in the overall relationship being viewed as controlling. Moreover, minority investors generally will need to pay careful attention to the non-exhaustive list of rights deemed to constitute limiting contractual rights under the Final Rule, as many of these rights are often regarded as standard minority investor protections in other (nonbanking) sectors.
D. Section 4(c)(6) Investments and the 5% Voting Safe Harbor
A key takeaway from the Final Rule is the extent to which the tiered framework further incentivizes minority investors seeking to avoid control to limit their investments to less than 5% of a company’s voting shares, taking any additional equity in the form of a non-voting security. Given the statutory presumption of non-control for investments involving less than 5% of any class of voting securities of a company and the exemption afforded under Section 4(c)(6) of the BHCA, there has always been a significant incentive for minority investors to consider limiting their voting power to 4.99% of an investee company. The Final Rule, however, provides even more reason for investors to consider this approach—particularly in circumstances where an investing company anticipates having any lending or other business relationship with the investee company other than its equity stake. As noted above, the tiered presumptions in the Final Rule provide that there is no presumption of control that can be triggered for a less than 5% voting investor based on business relationships or contractual rights, regardless of their magnitude or significance. In situations where the equity upside on a fintech or other investment by a BHC is not central to the business case for the investment—e.g., the more significant aspect is a financing arrangement or access to a particular technology—the Final Rule seems likely to encourage investors to structure more investments to come within the Section 4(c)(6) exemption.
Under the Proposal, one nuanced but important issue had been the extent to which a non-controlling investment involving less than 5% of a class of a company’s voting shares would also satisfy the “passivity” requirement for investments made under Section 4(c)(6) of the BHCA. Briefly stated, Section 4(c)(6) permits a BHC and its nonbank affiliates to invest in up to 5% of a class of voting shares of any company, so long at the investment is otherwise “passive” or “qualitatively limited.” The Final Rule appears to confirm that an investment in less than 5% of a class of voting securities that does not trigger a presumption of control (and, therefore, is presumed to be non-controlling) would likewise constitute a passive investment for purposes of Section 4(c)(6). Market participants may question whether there are levels of business relationships (perhaps coupled with contractual covenants or veto rights) that the Board would view as inconsistent with “passivity” notwithstanding the fact that, under the Final Rule, there is no presumption of control that can be triggered on the basis of those relationships or rights.
E. Non-Recognition of Larger and/or Majority Shareholders
One aspect of the Proposal that had actually represented a more restrictive approach to controlling influence determinations (as compared to the Board’s traditional approach) was the proposed non-recognition of the existence of an unaffiliated larger (or even majority) shareholder. The Board also proposed not to adopt different rules for closely- and widely-held companies. Notwithstanding industry comments urging that the tiered presumptions of control be amended to recognize impact of a larger, unaffiliated shareholder or an unaffiliated majority shareholder on an investor’s ability to exert a controlling influence, the Board declined in the Final Rule to afford any specific consideration or significance to this as a control factor. The Board’s rationale for excluding the existence of other larger/majority shareholders as a consideration appears to have been based largely on the Board’s view that this would have added substantial complexity to the framework. Nevertheless, one might reasonably question whether, in a close case where an investor seeks to challenge a presumption of control, the existence of a third-party majority shareholder might prove to be a compelling factor to help achieve that objective.
F. Investment Advisers and Investment Funds
The Final Rule retains the proposed presumption of control where a BHC (or other company) serves as investment adviser to an investment fund and controls 5% or more of any class of voting securities of the fund or 25% or more of the total equity of the fund. Such funds would themselves be regarded as subsidiaries of the BHC and therefore subject, among other things, to the restrictions in Section 4 of the BHCA. Notably, the Final Rule discards a limited exception from the general presumption of control for registered investment companies that had been included in the Proposal. The Final Rule’s presumption now extends to all manner of public and private investment funds, and would apply to investment advisers registered under the Investment Advisers Act of 1940, commodity trading advisors registered under the Commodity Exchange Act, and “foreign equivalents” of such registered advisers. While the presumption would not be triggered by a seed investment during the first year of operation of an investment fund, the Board declined to extend the seeding period exception to three years, as had been requested by many industry commenters.
One subtle but important clarification in the Final Rule that will be of interest to investment advisers and private equity or similar investors is a revision to the regulatory definition of “voting security” that states that limited partnership or LLC membership interests that provide for the removal of the general partner or managing member for cause, and the replacement of the removed general partner or managing member, will not cause those interests be treated as "voting securities." This clarification resolves some ambiguity in the definition of "voting securities," given that prior Board precedent and interpretations (some of them quite informal) have suggested that LP and LLC interests that contain a removal and replacement right even for cause might cause such interests to become BHCA “voting securities.”
G. Accounting Consolidation
Despite significant pushback from industry representatives during the comment period, the Final Rule retains the presumption of control where one company consolidates a second company for purposes of GAAP. While the presumption by its terms applies only to consolidation under US GAAP, the Board has stated that it also “is likely to have control concerns” when a company consolidates another company under some other accounting standard. This issue was a particular concern for certain FBO sponsors of US asset-backed commercial paper (ABCP) conduits, many of which consolidate their ABCP conduits for accounting purposes but had previously received comfort from Board staff that the conduits would not be regarded as controlled subsidiaries. This was a significant issue given that regulatory control over an ABCP conduit could subject the conduit to the Volcker Rule and/or the intermediate holding company (IHC) consolidation requirement under Regulation YY. Seeking partially to assuage these concerns, the Board notes in the preamble to the Final Rule that a “contractual relationship” that results in consolidation of a conduit or other company under the variable interest entity standard typically is not an “ownership interest” and, therefore, such a contract need not be consolidated under an IHC.
H. Attribution of Director Representatives
The number of director representatives attributable to an investor and the role(s) of those representatives on the board of an investee company continue to serve as significant control factors under the tiered framework in the Final Rule. However, the Board has substantially revised its approach for determining whether a particular director representative would be attributed to a company for purposes of its controlling influence analysis. Specifically, the Final Rule discards the approach included in the Proposal, which would have defined a “director representative” of a company broadly to include not only current and recently departed directors, employees, and officers of that company, but also immediate family members of such individuals and any person proposed to serve as a director by the company. Instead, the Final Rule defines a “director representative” of a company in a manner more consistent with the concept of control, namely as “an individual that represents the interests of a first company through service on the board of directors of a second company.” The Final Rule does provide “examples” of persons who would generally be considered director representatives (largely tracking the Proposal, except with respect to family members).
In adopting a definition based specifically on the interests being served by a particular director, the Final Rule suggests that a director nominated by a particular shareholder may not be attributed to that shareholder for control purposes if the director is truly independent and will not be “representing the interests” of the nominating shareholder. It does not, however, provide any insight into the circumstances under which such a director might be deemed to be sufficiently “independent,” meaning that as a practical matter any director nominated by an investor is likely at least as an initial matter to be presumed to “represent the interests” of the nominating investor.
I. Legacy Relationships and Passivity Commitments
As noted above, the Board declined in the Final Rule to provide any form of phase-in period or grandfathering with respect to any aspect of the control framework. This decision appears to have been based largely on the view that the Final Rule merely “provides additional information regarding the Board’s views on questions of controlling influence” and does not represent a “fundamental change to current practice.” Nevertheless, there are many examples where market participants have worked with Board staff to achieve a degree of comfort regarding non-control in the context of a particular investment or transaction, which, if the presumptions in the Final Rule were applied strictly, may now be called into question. With respect to such transactions, the preamble to the Final Rule provides some comfort, stating that “[t]he Board does not expect to revisit structures that have already been reviewed by the Federal Reserve System unless such structures are materially altered from the facts and circumstances of the original review.” For investors that have previously provided passivity commitments, the Board states in the preamble to the Final Rule that it generally expects to be able to grant relief from such commitments and encourages affected parties to contact the Board or the appropriate Reserve Bank.
On the Final Rule’s treatment of passivity commitments themselves, the Board has stated that it does not expect to rely on “standard-form passivity commitments” going forward in the ordinary course. Therefore, while the Final Rule appears to set aside a tool that has been used by investors in the past to avoid control determinations, the Board’s "in the ordinary course" qualification suggests that the Board does not propose to discard altogether the use of passivity commitments. How the Board or Board staff will approach this question going forward in specific cases cannot be known at this time, and, therefore, the extent to which passivity commitments will become a thing of the past remains to be seen.
J. Historical Ownership and Divestitures
The Final Rule carries forward the Board’s prior clarification in the Proposal of the standards for determining the presence of an investor company’s control of an investee company after a divestiture of the investee company’s voting shares. Thus, the Final Rule provides that an investor company that previously controlled an investee company during the preceding two years would be presumed to continue to control the investee company if the investor company owns 15% or more of any class of voting securities of the investee company (with the presumption of control falling away at the end of the two-year period). The Final Rule also adopts with minor modifications from the Proposal an exception to this presumption where nondirectors or nonsenior managers of the investor company, or unaffiliated investors, control 50% or more of each class of voting securities of the investee company. An investor company generally would be presumed to have achieved an effective divestiture of control (with no waiting period) if it reduces its investment to less than 15% of any class of voting shares and does not trigger any of the presumptions of control in the Final Rule. The Final Rule thus provides helpful concrete standards on a subject matter where prior Board positions on the control implications of divestitures were not always clear.
K. Impact on Statutory Control Criteria
We offer one concluding observation on the Final Rule, based on questions that we have received on its scope. Specifically, there are three prongs to the statutory definition of control under Section 2 of the BHCA, only one of which is the "controlling influence" prong addressed in the Final Rule. The BHCA also provides that one company controls another company when (i) the investor company directly or indirectly owns, controls, or has the power to vote 25% or more of any class of voting shares of the second company, or (ii) the investor company controls in any manner the election of the majority of the board of directors or trustees of the second company. These statutory definitions of control are unconditional, in that when either of these factors is present, the BHCA unambiguously provides that a control relationship exists. The Final Rule does not in any respect modify or carve back these two statutory elements of control.
[1] While there are minor statutorily driven distinctions in the Final Rule between banks and BHCs subject to the BHCA, on the one hand, and savings associations and SLHCs subject to HOLA, on the other hand, the Board has indicated that it generally intends to apply the same standards under both statutes. For the sake of simplicity, we refer below to banks and BHCs, but except as otherwise noted the analysis would generally apply equally to savings associations and SLHCs.
[2] The Final Rule does differ from the Proposal by applying the presumptions of control based on business relationships solely on the basis of revenues and expenses of the second, or investee, company, and not by reference to the revenues or expenses of the investor company.