Federal Reserve Board Proposes Codification of Control Principles from Lore into Law, Providing Greater Transparency to Potential Control Parties
By Lawrence Kaplan, Kelsey N. Sullivan
Years of regulatory lore as to the factors that determine when a party is deemed to “exercise a controlling influence” over a bank holding company (“BHC”) or a savings and loan holding company (“SLHC”) are being subjected to a new proposed rulemaking by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). This proposed rulemaking (the “Proposal”) will implement a tiered regulation designed to incorporate the major factors and thresholds that the Federal Reserve has typically viewed as presenting controlling influence concerns under the BHC Act, governing bank holding companies, and the Home Owners’ Loan Act (“HOLA”), governing savings and loan holding companies. The Proposal also provides transparency as to factors that could subject an investor to supervision by the Federal Reserve.
Companies (including their controlling shareholders) that are deemed to control a BHC or a SLHC or, indirectly, their depository institutions’ subsidiaries are subject to the Federal Reserve’s regulations and supervisory oversight, which includes regular examinations, financial reporting obligations,  capital and liquidity requirements, source of strength obligations, activities restrictions, and restrictions on certain affiliate transactions. Moreover, boards of directors and management of a controlling shareholder are subject to background investigations as to their fitness and character. While many companies are aware of the implications of such requirements when they seek to control an HC or a bank, such as a private equity firm, they only seek to make investments without being subject to the restrictions or obligations of a controlling shareholder of a BHC or a bank. Thus, whether or not an investor is deemed to control a BHC or SLHC or a depository institution can have significant implications on investors and the controlling shareholders of such investors.
The HC Acts and their respective implementing regulations each provide for similar definitions of “control.” These statutory and regulatory standards include bright-line ownership standards, such as when ownership of more than 25% of voting securities of an HC or a bank results in control. Similarly, control of the majority of the directors of an HC or a bank results in a company being deemed to control the HC or bank. 
The focus of the Proposal is the third tier of the statutory control tests in the HC Acts, when the Federal Reserve determines that a company directly or indirectly exercises a controlling influence over the management or policies of a bank or HC. This has historically raised significant ambiguities and subjectiveness, despite the guidance of a 2008 policy statement on equity investments that, in part, provided guidance with respect to such phrase.
To provide for transparency, the Federal Reserve is now proposing that, as an investor’s ownership percentage in a 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. As the Federal Reserve’s control principles apply to a variety of scenarios, including control of HCs, banks, and non-banking entities, the Proposal uses the term “first company,” which means the company whose control over the second company is the subject of a determination of control by the Federal Reserve. Similarly, the Proposal uses the term “second company,” which is defined as the company where the control of which by the first company is the subject of a determination of control by the Federal Reserve. While a first company and second company must meet the definition of “company” under the BHC Act or HOLA, as applicable, either could take a variety of legal entity forms, including a stock corporation, limited liability corporation, partnership, business trust, or foreign equivalents of such a legal entity. In the context of investments in HCs and banks, it is likely a first company would be an investor, and the second company, the target.
In sum, the Proposal addresses the following factors, based on common fact patterns that it has considered:
- The size of the first company’s/investor’s voting equity investment in the second company/target;
- The size of the first company’s/investor’s total equity investment in the second company/target;
- The first company’s/investor’s rights to director representation and committee representation on the board of directors of the second company/target;
- The first company’s/investor’s use of proxy solicitations with respect to the second company/target;
- Management, employee, or director interlocks between the companies;
- Covenants or other agreements that allow the first company/investor to influence or restrict management or operational decisions of the second company/target; and
- The scope of the business relationships between the companies.
Application of these factors is set forth in the chart, based on a chart issued by the Federal Reserve as a supplement to the proposed rulemaking:
|Amount of Equity→↓||
Less than 5%
|5–9.99% Voting||10–14.99% Voting||15–24.99% Voting|
|Seats on Board of 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||N/A|
|Amount of Equity Factor →↓||Less than 5% Voting||5-9/99% Voting||10-14/99% Voting||15-34.99% Voting|
|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 either company||Less than 5% of revenues or expenses of either company||Less than 2% of revenues or expenses of either 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||Less than one third||Less than one third||Less than one third||Less than one quarter|
In the Proposal, the Federal Reserve also is formally clarifying a variety of positions it has taken with respect to factors that can result in control. Several of the key provisions in the Proposal are below:
The Proposal reflects the Federal Reserve’s current practice for determining whether a company’s voting securities are owned, controlled, or held with power to vote by an investor and would provide rules for determining the percentage of a class of a company’s voting securities attributed to an investor. The Proposal clarifies that an investor is deemed to control a security if the person owns the security or has the power to sell, transfer, pledge, or otherwise dispose of the security. In addition, an investor would control a security if the person has the power to vote on the security, other than due to holding a short-term, revocable proxy.
The Proposal also codifies the Federal Reserve’s long-standing treatment of options or warrants to acquire a security or through control of a convertible instrument that may be converted into or exchanged for a security by codifying the Federal Reserve’s “look-through” approach, whereby an investor is deemed to control all securities that the investor could control upon exercise of any options or warrants. Similarly, a person would control all securities that the person could control as a result of the conversion or exchange of a convertible instrument controlled by the person. This approach is consistent with the Federal Reserve’s longstanding precedent of considering a person to control any securities (i) that the person has a contractual right to acquire now or in the future; and (ii) that the person would automatically acquire upon occurrence of a future event. The look-through approach applies even when a transaction is subject to an unsatisfied condition precedent to the exercise of the options and when options are significantly out of the money.
The Federal Reserve is proposing certain limited exemptions to the general look-through approach, such as for a purchase agreement to acquire securities that have not yet closed and to allow parties to enter into securities purchase agreements pending regulatory approval, due diligence, and satisfaction of other conditions to closing. In order to be eligible for this exemption, the securities purchase agreement must only be in effect for the time necessary to satisfy the closing condition. Thus, a company would be able to enter into a securities purchase agreement to acquire shares in a bank without being considered to control the shares until the closing, when the company would actually take ownership of the shares. This would allow the company to file any necessary notice or application with an appropriate federal banking authority, conduct due diligence, and prepare funds for the purchase. However, the company would be expected to file any required notice or application promptly and to work actively to satisfy any other closing conditions. The Proposal also exempts from the general look-through approach any options, warrants, or convertible instruments that would permit an investor to acquire additional voting securities only to maintain the investor’s percentage of voting securities, in the event the company increases the number of its outstanding voting securities.
Nonvoting Securities and Investor Protection Provisions
The Proposal revises the existing definition of “nonvoting shares” in a manner consistent with past Federal Reserve’s interpretations. Under the current definition of “nonvoting shares,” equity instruments are deemed to be nonvoting if any voting rights associated with the instruments are limited solely to the type customarily provided by statute with regard to matters that would significantly and adversely affect the rights or preferences of the instruments. 
Currently, Regulation Y provides a nonexclusive list of examples of the types of voting rights that the Federal Reserve has considered to be within the scope of the defensive voting rights that nonvoting shares may contain. The Proposal revises the definition of “nonvoting shares” to expressly permit defensive voting rights, commonly found in investment funds that are organized as rights of limited liability companies and limited partnerships, such as:
- the right to vote to remove a general partner or managing member for cause;
- the right to vote to replace a general partner or managing member that has been removed for cause or has become incapacitated; and
- the right to vote to dissolve the company or to continue operations following the removal of the general partner or managing member.
Finally, the Proposal revises the definition of nonvoting securities to make it clear that common stock cannot be a type of nonvoting securities, as the Federal Reserve notes that, for safety and soundness reasons, voting common stockholders’ equity should be the dominant form of equity. Moreover, this requirement could impact the capital structure of some fintechs that restrict voting power to a small class of voting securities.
Investor Control of Securities
Regulation Y currently provides that a person is deemed to control securities if the person is a party to an agreement or understanding under which the rights of the owner or holder of securities are restricted in any manner, unless the restriction falls under the exceptions specified under the rule. Thus, a person holding a long-term irrevocable proxy to vote on shares owned by another party would control the underlying securities subject to the proxy. The Federal Reserve is proposing six exceptions to this general rule:
The first exception is for rights of first refusal, rights of last refusal, tag-along rights, drag-along rights, or similar rights that are on market terms and that do not impose significant restrictions, including significant delay, on the transfer of the securities. While standard, market terms arrangements of this type would not result in the parties to such agreements controlling the securities subject to the arrangement, arrangements imposing significant, non-market-standard constraints on the transfer of securities would result in a control determination.
Second, the Proposal provides an exception for arrangements that restrict the rights of an owner or holder of securities when the restrictions are incidental to a bona fide loan transaction. Thus, if a creditor obtains a lien on the shares of a subsidiary of a debtor in connection with a bona fide loan transaction that prevents the debtor from selling the shares to a third party or pledging the shares as collateral to another creditor, the creditor would not be considered to control the shares of the subsidiary of the debtor. This is helpful to permit a creditor to perfect a security interest without first obtaining regulatory approval.
Third, the Proposal provides that an arrangement that restricts the ability of a shareholder to transfer shares, pending the consummation of an acquisition, does not provide the restricting party control over the shares of the restricted party. For example, if a person agrees to acquire shares of a banking organization from the current owner and the person is required to receive the approval of the Federal Reserve before acquiring the shares, the parties could agree that the current owner would not sell the shares to a third party, pending Federal Reserve approval and subsequent prompt consummation of the sale. In this fact pattern, the Federal Reserve would not deem the person to control the shares because of the agreement.
Fourth, the Proposal provides that an arrangement that requires a current shareholder of a company to vote in favor of a proposed acquisition of the company would not result in the proposed acquirer controlling the shares of the current shareholder. In order to qualify for this exception, the restriction may only continue for the time necessary to obtain governmental and shareholder approval and to consummate the transaction promptly.
Fifth, the Proposal exempts arrangements among the shareholders of a company designed to preserve the tax status or tax benefits of a company, such as qualifying as a Subchapter S Corporation or preserving tax assets (such as net operating losses) against impairment. However, in order to qualify for this exemption, the arrangement must not impose restrictions on securities beyond what is reasonably necessary to achieve the goal of preserving tax status, tax benefits, or tax assets.
Sixth, the Proposal provides that a short-term revocable proxy would not provide the holder of the proxy with control over the securities governed by the proxy. This would not interfere with the common practice of voting by proxy on matters presented for a shareholder vote, so long as the proxy is short in duration (i.e., is only valid for the next shareholder vote) and may be rescinded by the shareholder after being granted.
Finally, the Proposal also clarifies that a company that owns, controls, or holds with power to vote on 5% or more of any class of voting securities of a second company controls any securities issued by the second company that are owned, controlled, or held with power to vote by the senior management officials, directors, or controlling shareholders of the first company, or by the immediate family members of such individuals. Key to this clarification is the application of the requirement that the first party must hold 5% or more of any class of voting securities, thus eliminating the uncertainty of non-controlling parties deemed as acting in concert being deemed as exercising control as well.
Calculating the Amount of Equity Holdings
The Proposal provides a standard methodology for calculating a company’s total equity percentage in a second company that is a stock corporation that prepares financial statements, according to GAAP. Under GAAP, the balance sheet of a corporation reflects a dollar amount of equity for each class of stock that a corporation has issued.
The first step to calculating a company’s total equity in a second company would be determining the percentage of each class of voting and nonvoting common or preferred stock issued by the second company that the first company controls. For this purpose, all classes of common stock—whether voting or nonvoting—would be treated as a single class. If certain classes of common stock have different economic interests per share in the issuing company, the number of shares of common stock would be adjusted to equalize the economic interest per share. For example, if a company has Class A common stock and Class B common stock outstanding, and each share of Class B common stock has twice the economic interest in the company as each share of Class A common stock, each share of Class B common stock would be treated as two shares of common stock when aggregated with the Class A common stock.
Second, the percentage of each class of such stock controlled would be multiplied by the value of shareholders’ equity allocated to the class of stock under GAAP. For this purpose, the value of shareholders’ equity allocated to common stock would be all shareholders’ equity not allocated to preferred stock. Most significantly, this would mean that retained earnings would be allocated to common stock.
Third, the first company’s dollars of shareholders’ equity, determined under the second step, would be divided by the total shareholders’ equity of the second company, as determined under GAAP, to arrive at the total equity percentage of the first company in the second company.
Presumption of Non-Control
The Proposal expands the current presumption of non-control under the BHC Act, which provides that any company that controls less than 5% of any class of voting securities of a second company is presumed not to control the second company. The Proposal further extends a presumption of non-control to any investor that:
- controls less than 10% of every class of voting securities of a second company and
- is not presumed to control the target/second company under any of the control presumptions that apply at that ownership level.
The Proposal clarifies that a company would be presumed to control a second company if the first company has a contractual right that significantly restricts, or allows the first company to significantly restrict, the discretion of the second company over major operational or policy decisions. The Proposal provides examples of contractual provisions that generally would significantly limit a company’s discretion over major operational or policy decisions, as well as examples of contractual provisions that generally would not significantly limit discretion over such decisions. The examples are based on the Federal Reserve’s experience reviewing control fact patterns.
Investors with less than 5% of any class of voting securities would not be subject to a presumption of control based on contractual restrictions. However, where an investor has an ownership interest of greater than 5%, the following types of contractual provisions would provide an investor company the ability to restrict significantly the discretion of a second company with respect to fundamental business decisions:
- Restrictions on activities in which a company may engage, including:
- a prohibition on entering into new lines of business,
- making substantial changes to or discontinuing existing lines of business,
- entering into a contractual arrangement with a third party that imposes significant financial obligations on the second company, or
- materially altering the policies or procedures of the company;
- Requirements that a company direct the proceeds of the investment to effect any action, including to redeem the company’s outstanding voting shares;
- Restrictions on hiring, firing, or compensating senior management officials of a company, or restrictions on significantly modifying a company’s policies concerning the salary, compensation, employment, or benefits plan for employees of the company;
- Restrictions on a company’s ability to merge or consolidate, or on its ability to acquire, sell, lease, transfer, spin off, recapitalize, liquidate, dissolve, or dispose of subsidiaries or major assets;
- Restrictions on a company’s ability to make significant investments or expenditures;
- Requirements that a company achieve or maintain certain fundamental financial targets, such as a debt-to-equity ratio, a net worth requirement, a liquidity target, or a working capital requirement;
- Requirements that a company not exceed a specified percentage of classified assets or non-performing loans;
- Restrictions on a company’s ability to pay or not pay dividends, change its dividend payment rate on any class of securities, redeem senior instruments, or make voluntary prepayment of indebtedness;
- Restrictions on a company’s ability to authorize or issue additional junior equity or debt securities, or amend the terms of any equity or debt securities issued by the company;
- Restrictions on a company’s ability to engage in a public offering or to list or de-list securities in an exchange;
- Restrictions on a company’s ability to amend its articles of incorporation or by-laws, other than limited restrictions that are solely defensive for the investor;
- Restrictions on the removal or selection of any independent accountant, auditor, or investment banker; or
- Restrictions on a company’s ability to alter significantly accounting methods and policies, or its regulatory, tax, or corporate status, such as converting from a stock corporation to a limited liability company.
In addition to provisions that would result in a controlling influence, the Federal Reserve clarified that the following types of restrictions would not result in a finding of control:
- A restriction on a company’s ability to issue securities senior to the non-common stock securities owned by the investor;
- A requirement that a company provide the investor with financial reports of the type ordinarily available to common stockholders;
- A requirement that a company maintain its corporate existence;
- A requirement that a company consult with the investor on a reasonable periodic basis;
- A requirement that a company comply with applicable statutory and regulatory requirements;
- A requirement that a company provide the investor with notice of the occurrence of material events affecting the company or its significant assets; or
- A market standard “most-favored nation” requirement that the investor receive similar contractual rights as those held by other investors in a company; or
- Drag-along rights, tag-along rights, rights of first or last refusal, or stock transfer restrictions related to preservation of tax benefits of a company, such as S-corporation status and tax carryforwards, or other similar rights.
The Proposal clarifies that a director would be a “director representative of a company” if the director:
- is a current director, employee, or agent of the company;
- was a director, employee, or agent of the company within the preceding two years; or
- is an immediate family member of an individual who is a current director, employee, or agent of the company, or was a director, employee, or agent of the company within the preceding two years.
In addition, a director would be a director representative of a company if the director was proposed to serve as a director by the company, whether by exercise of a contractual right or otherwise. Finally, the Proposal will clarify that a nonvoting observer would not be deemed to be director representative.
While codifying the Federal Reserve’s past practices, the Proposal sets forth a series of questions for which the Federal Reserve seeks public comment. Paul Hastings is working with clients reviewing the Proposal, responding to such comments, and closely monitoring the regulatory process.
Click here for a PDF of the full text
 See proposed Federal Register notice available at: https://www.federalreserve.gov/newsevents/pressreleases/files/control-proposal-fr-notice-20190423.pdf
 12 U.S.C. 1841 et seq. and 12 U.S.C. 1461 et seq. As the two acts are similar, for convenience, they are jointly referred to as the “HC Acts” and banks and savings associations are jointly referred to as “banks.”
 \t12 U.S.C. § 1844(c); 12 CFR 225.5(c).
12 U.S.C. § 1844(c); 12 CFR 225.5(b).
 See, e.g., 12 CFR 225 app. C; 12 CFR part 217.
 12 U.S.C. § 1831o–1.
12 U.S.C. § 1843; 12 CFR 225 subpart C.
 12 U.S.C. §§ 371c and 371c-1; 12 CFR part 223.
 12 U.S.C. § 1841(a)(2), as implemented at 12 CFR 225.2(e) and 12 U.S.C. § 1467a(a)(2), as implemented by 12 CFR § 238.2(e).
 12 U.S.C. § 1841(a)(2)(B).
 12 U.S.C. § 1841(a)(2)(C).
 See Federal Reserve Policy Statement on equity investments in banks and bank holding companies (Sept 22, 2008) (the “Minority Investment Policy”). The Minority Investment Policy, which was issued by the Federal Reserve in the midst of the financial crisis, was never formally codified, but through frequent Federal Reserve citations to it, including the Proposal, such Minority Investment Policy has been validated.
 See 12 U.S.C. §§ 1467a(a)(1)(C) and 1841(b).
 See Minority Policy Statement.
 12 C.F.R. § 225.2(q)(2)(i).
 See 26 U.S.C. § 1361.
 See 26 U.S.C. § 382.
 Independently of whether controlling influence concerns are raised, agreements of this type may raise significant safety and soundness concerns under certain circumstances.