Evaluating the Federal Reserve's Control Proposal
On April 23, 2019, the Board of Governors of the Federal Reserve System (“Federal Reserve” or the “Fed”) issued proposed amendments to its regulations governing when a company is deemed to exercise “control” over another (“Proposal”).
The Proposal has significant implications for investments by and in banking organizations. In particular, the Proposal largely focuses on clarifying when one company would be deemed to exert a “controlling influence” over another under the Bank Holding Company Act of 1956, as amended (12 U.S.C. § 1841, et seq.). This test is frequently the crux of many control determinations issued by the Federal Reserve.
Three Control Tests. Under the Federal Reserve’s “control” tests, an entity is deemed to control a company when (1) such entity holds 25% or more of a class of voting securities of a company, or (2) such entity controls the election of a majority of a company’s board of directors. A third test provides that an entity directly or indirectly controls a company if the entity exercises a “controlling influence” over the management or policies of such company. While the first two prongs are straightforward, the third “controlling influence” prong typically entails a multi-factor review and analysis by the Fed.
Controlling Influence Test. In evaluating whether an entity exercises a “controlling influence” over another, the Federal Reserve considers regulatory precedent, policy guidance and other unpublished internal Fed practices. Specifically, the Fed’s review weighs an entity’s board representation at the target company, board roles held (e.g., chairman of the board), business relationships, overlapping or shared officers and directors, contractual restrictions on a target’s operations, and total investment equity held (“Control Criteria”). The Proposal would codify the Fed’s practices in evaluating Control Criteria to provide investors with greater certainty in expanding their rights and business relationships while being deemed noncontrolling.
Bank Holding Company Implications. Under U.S. banking law, an entity that controls a banking organization is required to register with the Federal Reserve as a “bank holding company” or “BHC.” As a registered BHC, such holding company is subject to comprehensive supervision, regulation, capital requirements, activities and investment restrictions, among other things. Moreover, entities “controlled” by a BHC are subject to the legal and regulatory restrictions applicable to the BHC banking organization itself (e.g., activities and investment restrictions, etc.).
Fintech Benefits. The Proposal, while largely consistent with the Fed’s current framework, makes several revisions that may prompt banks to make greater investments in fintech firms. These include targeted adjustments to expand ownership thresholds, and a new rebuttable presumption of noncontrol that presumes an entity does not control another where such entity controls less than 10% of every class of voting securities (such threshold was previously 5%) and such entity is not otherwise “exercising control” under other presumptions.
Divestiture. The Proposal also relaxes requirements for divestiture of control to provide investors with greater flexibility. Current requirements specify that an investor must divest to hold less than 5% of voting shares to terminate a control relationship. Under the Proposal, however, an investor no longer maintains “control” if such investor:
Owns less than 15% of voting securities, or
Holds between 15% and 25% of voting securities and remained at such level during the two preceding years.
This revised approach provides investors with greater flexibility in exiting positions and allows investors to terminate control while retaining more than 5% of voting securities.
The following chart outlines distinctions between the Federal Reserve’s current practices and the Proposal with respect to the Fed’s “controlling influence” test.