Financial Institution Developments

Edward D. Herlihy and Richard K. Kim are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell memorandum.

Last week, the Board of Governors of the Federal Reserve System approved a final rule to codify its standards for determining whether one company has control over another. The final rule takes effect on April 1 and completes the process that the Federal Reserve began last April by issuing a proposal seeking public comment. Despite extensive industry input that urged the Federal Reserve to take a more expansive view, the Federal Reserve generally dismissed the comments received and largely adopted the control rule as initially proposed. Although this was disappointing to many in the industry, the impact of the control rule will nevertheless be significant with clear winners and losers. Beneficiaries of the final rule include investors in banks, including private equity and activists, who are permitted more board seats and governance rights than under the prior policy. Conversely, banks looking to invest in fintech and other companies, as well as fintech companies seeking to own banks, did not receive the flexibility that they had been seeking.

Implications for Private Equity and Activist Investors

Historically, private equity has had a checkered relationship with the banking industry. There are significant implications if a company is deemed to control another—for example, a private equity fund that controls a bank would subject the fund and the firm to regulation as a bank holding company, an impossible burden for all but a handful of private equity firms that specialize in investing in banks. For these reasons, private equity investments in banks are carefully structured as passive investments to avoid a finding of control by the Federal Reserve. Prior restrictions, which limited private equity investors to one director on a board and barred that director from becoming chairman or even joining key committees, were powerful disincentives. Because private equity is generally costly capital, banks are typically most receptive to it in times of difficulty—precisely the times when private equity investors would want meaningful board representation in order to ensure that the bank is appropriately addressing its issues. Similarly, barring investors from key committees, such as the executive committee or the audit committee, effectively handcuffed them at a time when a financially sophisticated and independent perspective would be most helpful to the bank in curtailing unsafe and unsound practices or detecting malfeasance.

Under the final rule, a private equity or other investor can acquire up to 24.99% of the voting shares of a bank and appoint directors up to just less than a quarter of the bank’s board. These directors may also serve on all of the key committees as long as they represent less than a quarter of the membership. If an investor holds 14.99% or less of a bank, it may even appoint the chairman of the board. As a result, it is now possible for an investor to effect real change at a bank without being deemed to control it.

At the same time, banks should be cognizant that the final rule also provides activist investors with the same set of tools. In addition to greater board representation, the final rule permits investors to conduct a proxy solicitation in opposition to a company’s board of directors without triggering a presumption of control. Previously, noncontrolling investors were often required by the Federal Reserve to enter into passivity commitments which prohibited them from soliciting proxies on any matter and from proposing a slate of directors in opposition to a slate proposed by the management or board of a company. The final rule removes these restrictions completely for investors with less than 10% of the voting shares of a company. Investors with between 10% but less than 25% can also solicit proxies and propose a slate to replace up to (but
less than) a quarter of the board.

Implications for Fintech

The final rule imposes stringent limitations on the level of business relationships that a noncontrolling investor may have with a company without being deemed to control it. These limitations fell well short of the relief for which the banking industry had hoped. If a bank acquires between 15% and 24.9% of a fintech or other company’s voting shares, the bank must limit its business relationships with the company to less than 2% of the company’s revenues or expenses. Otherwise, the company may be deemed by the Federal Reserve to be controlled by the bank and become subject to Federal Reserve regulation. The Federal Reserve’s limitation on business relationships greatly complicates a bank’s ability to invest in a fintech company and adopt its technology, making it all but impossible for large banks to make a meaningful investment in a startup fintech company and also become a major customer without being deemed to control the company.

Similarly, the final rule’s requirements that govern how a controlling relationship may be severed complicates the ability of fintech companies to acquire or establish banks. It is fairly common for technology companies to be controlled by one or more venture capital funds. Unless these control linkages are severed, the acquisition of a bank by a fintech company would subject the venture capital funds to bank regulation. In order to break control, the final rule requires that the controlling investors divest down to less than 15% of the company’s voting shares which may not be palatable for many investors.

Overview of the Final Rule

Under the Bank Holding Company Act, there are two bright line tests as to when control is deemed to exist—ownership or control of 25% or more of any class of voting securities or the ability to elect a majority of the board of directors. There is also a third and more subjective test—whether there is the ability to exercise a controlling influence over the management or policies of the company. [1] The final rule is intended to clarify precisely when a controlling influence is deemed to exist. The final rule accomplishes this by establishing four tiers of presumptions of noncontrol that are based on the percentage of voting shares held by the investor:

  • less than 5%;
  • 5% to 9.9%;
  • 10% to 14.9%; and
  • 15% to 24.9%. [2]

The higher the percentage ownership, the fewer the indicia of control that are permitted. These indicia of control include director representation, business relationships, restrictive contractual covenants and proxy contests and are discussed below.

Directors. As noted above, the final rule’s most significant change is that it would materially increase the number of directors that an investor may have in a company without being deemed to have a controlling influence. Previously, a noncontrolling investor with 5% or more of the voting shares of a company was typically limited to a single director with very few exceptions. Under the final rule, an investor with 5% or more but less than 25% of the voting shares of a company can now have up to (but less than) a quarter of the directors serving on the board. If an investor holds less than 5% of the voting shares of a company, it may have up to (but less than) half of the directors serving on the board. In addition, the final rule permits director representatives to have broader roles on the board than in the past. Previously, a director representing a noncontrolling director was not permitted to chair the board or its key committees or even participate at all in influential committees that have the power to bind the company. Under the final rule, if an investor holds less than 10% of the voting shares of a company, it is free from all of these restrictions. As summarized in the Appendix, these rights become slightly more limited as the percentage of voting shares increases. As noted above, in a significant departure from prior policy, the final rule greatly expands the ability of noncontrolling investors to engage in proxy solicitations and to propose a slate of directors.

Business Relationships. The level and type of business relationships that the Federal Reserve has permitted in the context of a noncontrolling investment has varied greatly over the years. Under the final rule, if an investor holds:

  • less than 5% of the voting shares of a company, there are no limitations on business relationships between the two;
  • between 5% and 9.9% of the voting shares of the company, business relationships must be limited to 10% of the revenues or expenses of the company;
  • between 10% and 14.9% of the voting shares of the company, business relationships must be limited to 5% of the revenues or expenses of the company and be on market terms; and
  • between 15% and 24.9% of the voting shares of the company, business relationships must be limited to 2% of the revenues or expenses of the company and be on market terms.

Severing Control. The final rule also imposes requirements as to how to sever control. Previously, the Federal Reserve frequently required investors to divest to below 5% of the voting shares of a company in order to sever control. Under the final rule, a company would no longer be deemed to control another company if:

  • The first company holds less than 15% of the voting shares and would not trigger any presumption of control; or
  • More than 50% of the voting shares are controlled by an unrelated party.

Although the final rule is disappointing to some in the industry who had hoped for more fundamental changes, it nevertheless represents a significant shift in an important and far-reaching regulatory policy. The implications will be felt for years to come.

Endnotes

112 U.S.C. § 1841(a)(2); 12 U.S.C. § 1467a(a)(2).(go back)

2Attached as an Appendix is the Federal Reserve’s matrix that summarizes the four tiers and the related presumptions.(go back)

Appendix

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 one interlock, never CEO No more than one 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-third
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