Federal Reserve Proposed Control Regulations
The Federal Reserve proposed a comprehensive clarification to its control regulations and related requirements earlier this year, with comments due in July 2019. The Fed received 25 comment letters on their proposal, mostly from banking and financial services trade associations as well as from law firms representing banks and from some banks directly. The Fed's proposal combines its efforts to clarify the control provisions under the Bank Holding Company Act as well as the Savings and Loan Holding Company Act which the Fed now also has jurisdiction and supervisory responsibility. The BHCA is limited to companies becoming bank holding companies and directly or indirectly acquiring control over banks. The S&LHCA includes individuals as well as companies acquiring direct or indirect control over thrift entities.
The Fed proposal is quite lengthy and complex. It is difficult to present a pithy summary of the release. In general, the Fed is reacting to criticism that its control review process lacked transparency and made it difficult for industry to plan and structure permissible investments in banks or bank holding companies.
In broad terms, the Fed's control provisions have two bright line tests establishing control when a company acquires more than 25% of any class of voting security of the "target" bank or bank holding company, or if a company controls the majority of the directors of the "target" bank or bank holding company. The third prong of the control definition permits the Fed to determine control exists after a notice and comment hearing which examines a range of factors including several items relating to presumptions of control.
In short, what the Fed proposal aims to do is to focus on bringing greater clarity to the third prong of the control definition by providing a "tiered" approach to control so as the potential investor obtains a higher percentage of voting stock then other presumptions involving the ability to elect directors, maintain a business relationship with a target bank or bank holding company, and other non-investment factors generally become more limited or restricted under the proposal. The tiered approach is a continuum, or a sliding scale, so as a parallel matter, if the potential investor obtains a lower percentage of voting stock then the other non-investment presumptions involving a target bank or bank holding company become more liberal and less restricted.
The Fed is reviewing the comments received. Since this is a very complicated topic and the Fed has only previously reviewed it in 1970, 1982, 1984, 2008 as a result of statutory changes or because of pressing bank policy developments, I would expect that it may take a year or longer before there is either a final proposal or possibly an updated, revised proposal for comment. Importantly, as the Fed noted, its prior guidance and interpretations in this area had not generally been issued with public notice and comment.
Having summarized the general overview of the proposal without addressing in granular detail the presumption levels triggered at the tiers of: less than 5% voting; 5-9.99% voting; 10-14.99% voting; and 15-24.99% voting, I will nonetheless "call out" some interesting aspects of the proposal which may represent unintended consequences by the Fed.
- Accounting issues:The proposal would require an investor company which consolidates a investment of less than 25% voting position onto the investor company balance sheet as a subsidiary, to concede that the investor company controls such an entity. There are nuances here as to whether GAAP accounting conventions are being used, or some other accepted accounting conventions are being used, but this is a really big "rabbit hole" for the Fed to jump into knowingly, or not. This could become very complicated for the foreign banks that they regulate and the use of foreign systems of accounting. The Fed could back away from this broad range of consequences by limiting the accounting consolidation to principal subsidiaries using common equity tests. If the Fed does not limit the proposal, then undoubtedly, a wide range of complicated banking and thrift organizational structures which use conduits to issue commercial paper, involve securitization transaction/trusts and other commercial arrangements will be impacted if they are considered controlled by the bank or thrift entity. I have a great deal of respect for the talent level at the Fed, but I would not say that accounting theory and policy is an area where the agency excels.
- Safe harbor of less than 5%: The Fed proposal is constructed in a manner so that a company with a less than 5% voting position in a bank or bank holding company is not considered to be in a control position. I would argue that this is a longstanding position of the Fed which is consistent with the BHCA and Fed guidance. I am sure that there are other banking lawyers who can point out contradictions with this conclusion, but I certainly have given this advice on this point for over 30 years of law practice.
- Need to remember the Fed's expansive views of capital markets. The Fed has an expansive view to "count" various positions such as options as though they were already exercised when it is totaling up the voting control position of a potential investor calculating its voting shares that it owns. Likewise, the Fed takes an expansive view of what debt instruments constitutes equity when it is applying its total equity limits presumption generally of up to one third although it is up to one quarter presumption under the proposal if the investor owns 15-24.99% voting shares.
- Fed may have taken on a bigger project than they imagined. Reflecting some of the comment letters, I am in agreement that the Fed should look to "synch up" its views on tiered voting stock positions with the Change in Bank Control Act (CIBCA). The law requires an entity that is not subject to file with the BHCA to still consider whether it needs to file under the CIBCA, which has filing presumptions at the 10% level as well as at the 25% level. In consideration of its updated views on control under the BHCA, the Fed also likely should seek to update its views on control under the CIBCA and possibly look to synch up investment levels under the merchant banking rules for banks and what constitutes a controlled banking entity for Volcker rule purposes.
- This clarification of control is inherently a big bank matter. There is one comment filed to this effect: smaller community banks and regional banks may have very limited time periods to have additions made to a bank's capital. This is due to family changes of its investor shareholders or other "lumpy" events that impact smaller banks. Under real time market timing considerations, by the time, a smaller bank or even a regional bank were to get an answer back from the Fed or its reserve bank that a proposed addition to the bank's capital is fine and does not raise control issues, the opportunity to have that capital secured by the bank may be long gone.
I am happy to discuss the Fed proposal and the comments with interested parties.
Tim McTaggart