Seeking to increase the transparency of the rules for determining control of a banking organization, the Federal Reserve Board of Governors (Board) asked for public comment on a new proposal.
The proposed changes would provide clarity and consistency of decision making to banks and investors, the Board said.
What happened
The Bank Holding Company (BHC) Act and Home Owners’ Loan Act (HOLA) define control using a three-pronged test. A company has control over another company if the first company (i) directly or indirectly, or acting through one or more other persons, owns, controls or has power to vote 25 percent or more of any class of voting securities of the other company; (ii) controls in any manner the election of a majority of the directors of the other company; or (iii) directly or indirectly exercises a controlling influence over the management or policies of the other company.
While the first two prongs are bright-line standards that can be easily understood, the third prong is a “facts and circumstances” determination by the Board. “As a result, it is often difficult for an investor seeking to avoid making a controlling investment to ensure that the investment will, in fact, be considered noncontrolling by the Board,” according to the Federal Register notice.
Although the Board has issued public and private interpretations on the topic of control, uncertainty has remained for banking organizations and their investors about whether or not a proposed investment is controlling, the Board explained. To remedy that problem, the new proposal sets forth a “tiered framework for control determinations.”
The proposed tiered presumptions are based on a company’s level of voting securities of another company, with four levels of voting ownership: less than 5 percent, 5–9.99 percent, 10–14.99 percent and 15–24.99 percent. The framework would then apply factors such as the size of a company’s total voting and equity investment; rights to director representation; the use of proxy solicitations; management, employee and director interlocks; agreements that restrict or influence management or operational decisions; and the scope of business relationships.
Pursuant to the structure of the framework, as a company’s or an investor’s ownership percentage in the target company increases, the additional relationships and other factors through which the investor could exercise control generally must decrease in order to avoid triggering the application of a presumption of control.
The proposal generally codifies the Board’s historical practice with respect to controlling influence, but also features “targeted adjustments the Board believes are appropriate based on its experience,” such as permitting an investor to have a greater number of director representatives at the target company and to solicit proxies in opposition to management without triggering a presumption of control, and allowing investors seeking to terminate an existing control relationship to do so while retaining greater levels of ownership. The proposal also clarifies that the market term standard investor-protective provisions customarily included in venture capital and private equity investments (drag-along and tag-along rights and rights of first refusal, for example) will not trigger control determinations, but protective provisions deemed by the Board as “significant, non-market-standard constraints” could be indications of control. It is unclear how the Board will make these determinations of standard and non-market terms. Interestingly, the proposal is silent regarding passivity commitments, which have become de rigueur for investors in bank holding companies that seek noncontrol determinations by the Board.
The proposal also expands the existing rebuttable presumption of noncontrol. Currently, under the BHC Act, a company that owns less than 5 percent of the voting securities of another company is presumed not to control the other company. The proposal would establish a new presumption of noncontrol, where a company that owns less than 10 percent of the voting securities of a second company does not trigger any of the presumptions of control.
“The Board’s control framework has developed over time through a Delphic and hermetic process that has generally not benefited from public comment,” Vice Chair for Supervision Randal K. Quarles said. “This proposal would place substantially all of the Board’s control positions into a comprehensive public regulatory proposal and allow public comment on those positions to improve their content and consistency.” At the same time, the proposal in several places reminds us that despite the new presumptions, “the Board may or may not find there to be a controlling influence based on the facts and circumstances presented by a particular case.”
Why it matters
“Providing all stakeholders with clearer rules of the road for control determinations will responsibly reduce regulatory burden,” Federal Reserve Chair Jerome H. Powell said in a statement about the proposal. “As a result, it will be easier for banks, particularly community banks, to raise capital to support lending and investment.” And given the new clarity regarding certain investor-protective provisions, it may be easier for bank holding companies to attract venture capital and private equity funding. Similarly, bank holding companies may be at greater risk of attracting the attention of “noisy” investors who will feel more comfortable knowing the bright-line tests that trigger control. Comments on the proposed rule will be accepted for 60 days after publication in the Federal Register. We will be providing supplemental information on this important proposal following issuance of the final rules.