February 7, 2020

US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules

On January 30, 2020, the Board of Governors Key Takeaways of the Federal Reserve System (“Board”) approved a final rule (“rule” or “final rule”) to Before turning to a detailed review of the rule, revise and codify its approach for determining we note several significant takeaways and whether one company has control over potential considerations: another company for purposes of the US Bank  Framework for Determining Control Is Holding Company Act of 1956 (“BHCA”) and Expanded and Codified: The rule the Home Owners’ Loan Act (“HOLA”), as introduces several “presumptions of 1 amended. The rule amends Regulations Y control” into the Board’s regulations. The and LL, which implement the BHCA and HOLA, centerpiece of the rule is a “tiered respectively. framework” of presumptions where the level The final rule, which substantially revises and of voting share ownership is assessed in augments the existing regulatory framework combination with relationship-based factors for interpreting the controlling influence to determine whether one company is prong of the statutory test for control, largely presumed to control another. Although the mirrors the proposed rule2 that was issued in tiered framework structure is new, many of April 2019 (“proposal”). While in many the presumptions that comprise the respects the final rule codifies the Board’s framework are generally consistent with the existing control standards, it also introduces Board’s historical practices. new concepts and raises critical questions  Triggers a about how the Board will implement the rule “Presumption of Control”: The final rule in practice. diverges sharply from the Board’s current This Legal Update explains and analyzes key approach to control with respect to the aspects of the Board’s rule and highlights treatment of accounting consolidation. changes from the proposal. The final rule will Under the final rule, a company that take effect on April 1, 2020. consolidates a second company on its financial statements under US GAAP is presumed to control the second company regardless of its voting level in the company. This presumption is likely to contact the Board or its staff to seek impact a number of arrangements clarification. previously considered non-controlling.  No Transition Period to Conform:  Control Through “Business Notably, the final rule does not (i) provide a Relationships” Measures and transition period to allow firms to conform : One of the factors considered in or report existing investments, and (ii) the “tiered framework” is the extent of the include any grandfathering provisions for company’s business relationships any types of existing arrangements, with the investee company, defined structures or investments. quantitatively through measurement of and expenses. This marks a shift Background from the Board’s historical approach, which focused primarily on revenue only. In a “Control” is a foundational concept under the change from both the proposal and the BHCA and HOLA. Under the BHCA, a company Board’s historical practice, the final rule that indirectly or directly controls a bank or measures the significance of the business savings association is a considered a bank relationship from the perspective of the holding company (“BHC”) or savings and loan investee company only. holding company (“SLHC”), respectively, and is subject to subject to the Board’s supervision  Rule Does Not Apply to Other Regulatory and regulation, including examination, Definitions of “Control”: The definitions of periodic reporting, and restrictions on “control” in the final rule apply only to engaging in activities that are not financial in Regulations Y and LL and do not extend to nature or incidental or complementary to a or modify the concepts of control under the financial activity.3 A company that is Change in Bank Control Act or the Board’s controlled by a BHC or SLHC similarly is Regulation O or Regulation W. subject to Board supervision and regulation  Consultation with Board Staff Not and restrictions regarding its activities.4 Eliminated: Historically, the Board, through Additionally, companies that control a bank Board staff, decided most questions of (i.e., BHCs) or are controlled by or under control based on the specific facts and common control with a bank (i.e., the bank’s circumstances presented by each particular affiliates) are subject to prohibitions against case. When the proposal was introduced in and certain covered fund April 2019, comments by the Board and relationships under the Volcker Rule. Board staff framed it as a “broadly applicable and uniform set of rules to The BHCA defines control through a three- address the large majority of control fact pronged test. A company has control over patterns” that would reduce the “substantial another company if the first company compliance and uncertainty burden” (i) directly or indirectly or acting through one created by the case-by-case approach to or more other persons owns, controls, or has control. However, the final rule does not power to vote 25 percent or more of any class appear to eliminate the need for of voting securities of the other company; consultation with Board staff to the extent (ii) controls in any manner the election of a promised. On the contrary, several majority of the directors of the other provisions in the final rule emphasize the company; or (iii) the Board determines, after fact-specific nature of the control notice and opportunity for hearing, that the determination and refer companies to company directly or indirectly exercises a

2 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules controlling influence over the management or specific circumstances that result in non- policies of the other company (emphasis control; (v) additional definitions related to added). 5 control amended or added by the rule; (vi) the application of the rule to SLHCs and foreign The meaning of the “controlling influence” banking organizations (“FBOs”); and (vii) the prong of the definition has been developed interaction of the rule with other regulatory primarily through staff determinations on definitions of control. individual transactions, often without any public notice or comment, rendering the DETERMINATION OF CONTROL applicable legal doctrine opaque to other The BHCA provides that control due to companies and their counsel. Even Board staff controlling influence arises following a Board acknowledge that the control framework “is determination that a company controls not provided in a single document and many another company. Since the 1980s, the Board of the specific standards have not been issued has not issued formal control determinations publicly.”6 The complexity and relative lack of (i.e., following notice and the opportunity for a transparency of this case-by-case approach to hearing) as contemplated in the BHCA and control made it difficult for banking firms and Regulation Y. Rather, Board staff have in banking firms to determine reviewed proposed transactions and situations whether a particular proposed investment that potentially present controlling influence could give rise to control concerns. concerns and communicated their views to investors and target companies.7 Several Analysis places in the final rule explicitly contemplate a The rule is intended to improve the continued need for informal consultations predictability and simplicity of the Board's with Board staff to determine whether control framework by establishing a broadly structures present the possibility of a applicable and uniform set of rules to address “controlling influence.” the large majority of control fact patterns. The Continued Board Staff Role central element of the rule is the addition of a new tiered framework of “presumptions of Although one of the stated aims of the control” based on combinations of (i) voting proposal was to reduce the need for fact- interest levels and (ii) factors indicating the specific determinations by Board staff, several potential for one company to control another, provisions in the final rule emphasize the fact- such as management interlocks or board specific nature of control determinations. influence. The rule supplements the tiered Companies are encouraged to contact the framework with standalone presumptions and Board or its staff for clarification regarding: provides -sought clarity around several  Whether certain contractual provisions are control-related concepts, such as how total “limiting contractual rights” that would equity interest is to be calculated. trigger a presumption of control; This Legal Update describes (i) the formal and  Whether a particular holding of securities informal procedures for determination of would qualify for the fiduciary exception; control; (ii) the new presumptions of control  Whether a particular individual would be related to the “tiered framework,” including considered to be a director representative; the relationship-based control factors; (iii) the and additional standalone presumptions of control  Whether certain equity instruments would separate from the “tiered framework”; (iv) the be excluded from total equity.

3 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules Non-Exclusive Framework previously reviewed by “the Federal Reserve Notwithstanding the proposal’s stated goal of System,” companies are encouraged to establishing a “broadly applicable and uniform “contact the Board or its staff to discuss set of rules”8 for applying the controlling potential actions.” influence prong, the final rule retains the Moving forward, we expect determinations Board’s discretion to find that a “controlling regarding the existence of “controlling influence” exists, including in situations that influence” to continue to be made through do not trigger any of the presumptions of informal discussions and fact-specific opinion control. For example, in connection with letters with respect to (i) new arrangements, “business relationships” in the new tiered structures or investments and specific presumption framework, the final rule states relationships and (ii) existing arrangements, that “[a]lthough the final rule is expected to structures or investments that may arguably cover most controlling influence concerns trigger a presumption of control under the arising out of business relationships, the Board rule that have not previously been reviewed may raise controlling influence concerns under by a component of the Federal Reserve specific facts and circumstances consistent System. The need for clarification regarding with historical precedent, such as relationships existing arrangements, structures or 9 with special qualitative significance.” investments could place significant pressure on Board staff and the industry between now Reassessment of Existing Arrangements, and the April 1 effective date. Structures and Investments The need for fact-specific consultation with PRESUMPTIONS OF CONTROL RELATED Board staff may also extend to existing TO THE “TIERED” FRAMEWORK arrangements, structures or investments that A presumption that one company has a have not been explicitly reviewed by a “controlling influence” on another applies component of the Federal Reserve System where the first company controls at least a (e.g., Board, Board staff, Reserve Bank). The specified level of a class of voting securities of final rule (i) does not provide a transition the second company, plus another specified period to allow firms to conform or report relationship with the second company based existing arrangements, structures or on the existence of one or more “control investments, and (ii) does not include any factors,” such as director representation on grandfather provision for non-conforming the second company’s board, total equity existing arrangements, structures or ownership in the second company, or business investments. In general, the Board “does not relationships with the second company. As the expect to revisit structures that have already first company’s voting interest percentage in been reviewed by the Federal Reserve System” the second company increases, other factors unless such structures are “materially altered through which the first company could from the facts and circumstances of the exercise a controlling influence generally must original review.” However, in cases where decrease in order to avoid triggering the structures that could trigger a presumption of application of a presumption of control. control under the rule have not been

4 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules The tiered framework of presumptions of control, with the voting interest levels and the control factors, is summarized in the table below. A presumption of control is triggered if any relationship exceeds the amount on the table.

Control of a Percentage of a Class of Voting Securities

Less than 5% 5-9.99% 10-14.99% 15-24.99%

Less than a Less than a Less than a Directors Less than half quarter quarter quarter

No director Director Service N/A N/A N/A representative is as Board Chair chair of the board

A quarter or less A quarter or less Director Service of a committee of a committee on Board N/A N/A with power to with power to Committees bind the bind the company company

s Less than 10% of Less than 5% of Less than 2% of r o

t Business revenues or revenues or revenues or c N/A a

F Relationships expenses of the expenses of the expenses of the

l

o second company second company second company r t n o

C Business Terms N/A N/A Market Terms Market Terms

d e s No more than 1 No more than 1 a

B Officer/Employee

- N/A interlock, never interlock, never No interlocks p

i Interlocks

h CEO CEO s n o i

t No rights that No rights that No rights that a

l Contractual No management

e significantly significantly significantly

R Powers agreements restrict discretion restrict discretion restrict discretion

No soliciting No soliciting proxies to replace proxies to replace Proxy Contests more than N/A N/A more than (Directors) permitted permitted number number of of directors directors

BHCs - Less than BHCs - Less than BHCs - Less than BHCs - Less than 1/3 1/3 1/3 1/3 Total Equity SLHCs – 25% or SLHCs – 25% or SLHCs – 25% or SLHCs – 25% or less less less less

5 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules The tiered framework in the final rule is largely Under the rule, a company will be presumed consistent with the framework described in to control another company when: the proposal with several notable differences  The first company controls 5 percent or discussed below. more of any class of voting securities of the second company and has business Director Representation relationships with the second company that The definition of director representative in the generate in the aggregate 10 percent or final rule has been narrowed from the more of the total annual revenues or definition in the proposal. In particular, the expenses of the second company; final rule’s definition of director  The first company controls 10 percent or representatives does not per se include more of any class of voting securities of the immediate family members of a first second company and has business company’s directors, employees, and agents. relationships with the second company that Under the final rule, “director representative” generate in the aggregate 5 percent or is defined as an individual that represents the more of the total annual revenues or interests of the first company through service expenses of the second company; or on the board of directors of a second company. The final rule provides a non-  The first company controls 15 percent or exclusive list of examples of persons generally more of any class of voting securities of the considered to be director representatives.10 second company and has business relationships with the second company that The final rule adopts the proposal’s generate in the aggregate 2 percent or presumptions with respect to the number of more of the total annual revenues or director representatives on the board of expenses of the second company. another company, including those serving as chair or on board committees with power to The final rule adopts the proposal’s bind the second company. presumption of control for business relationships that are not on market terms. Business Relationships The rule does not include a presumption of Notwithstanding the requests of many control based on threats to alter or terminate commenters, the final rule retains the business relationships, although the Board quantitative threshold levels that were indicated that such actions may be relevant to included in the proposal. However, in a determinations of control. moderate narrowing compared to the proposal, the final rule requires evaluation of Senior Management Interlocks revenues and expenses from the perspective The rule defines “senior management official” of the second company only (not both to be any person with authority to participate 11 companies). While this clarification is helpful, (other than as a director) in major policy the quantitative thresholds remain very making functions of a company. The Board restrictive and could present problems for emphasized that this definition is to be some existing arrangements, structures or interpreted based on the function that a investments and potentially limit future person serves rather than a person’s official arrangements involving small or start-up title. The Board noted that it will consider entities. providing additional clarity around this definition at a later time.

6 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules Contractual Limits on Major Operational or available to common shareholders, whether Policy Decisions or not the information is financial in nature, Under the rule, a company is presumed to is generally not a limiting contractual right. control another company if the first company Similarly, an investor’s right to access controls five percent or more of any class of information regarding the relationship voting securities of the second company and between the investor and the investee also has a “limiting contractual right” with company is generally not a limiting respect to the second company. A limiting contractual right. contractual right is a contractual right that  Restrictive Loan and Bond Covenants: allows a company to significantly restrict the Commenters expressed concern that the discretion of a second company, including its definition of limiting contractual right would senior management officials and directors, cover standard loan or bond covenants, over major operational or policy decisions. including in situations where a company has parallel debt and equity investments To help clarify the definition, the rule includes in a target company and the debt nonexclusive lists of examples of contractual investment document contains a limiting rights that are generally (i) considered to be contractual right. limiting contractual rights or, alternatively, (ii) not considered to be limiting contractual The Board acknowledged that it has “long rights. The Board explained how common recognized that … many loan agreements contractual revisions will be evaluated against contain restrictive covenants and that the the definition of limiting contractual right: existence of these covenants has not been sufficient, in itself, to constitute a controlling  Activities Restrictions: A contractual influence. Thus, the Board generally has not prohibition on engaging in particular viewed restrictive covenants in the context activities is generally a limiting contractual of loan transactions or commercial services right. However, a contractual provision that to raise controlling influence concerns.” provides a reasonable and non-punitive mechanism for an investing company to However, the final rule does not specifically reduce its investment to comply with the exempt restrictive covenants in debt activities restrictions of the BHCA or HOLA agreements from the definition of limiting is generally not a limiting contractual right. contractual right and does not foreclose the possibility that a restrictive covenant  Provisions Prohibiting “Materially embedded in a market-standard loan Altering Policies and Procedures”: In agreement could nonetheless be a limiting response to a comment, the Board stated contractual right that would trigger a that a contractual right that restricts presumption of control. “materially altering policies or procedures” is generally considered a limiting  Comparison to Management Agreements: contractual right, explaining that it “is The Board explained that its concern with similar to the example of a limiting limiting contractual rights generally arises contractual right provided in the final rule from the combination of a limiting related to amendments to the articles or contractual right and control over a material bylaws of a company.” share of voting securities. This contrasts  Contractual Rights to Investor with the approach to management Information: The Board clarified that a agreements, which raise control concerns contractual right to information ordinarily regardless of the share of voting securities controlled.

7 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules Total Equity Ownership control for a company that solicits proxies With respect to the presumptions of control from the shareholders of another company. based on total equity ownership, the final rule Under the rule, a non-controlling investor contains two key changes from the proposal generally may act as a shareholder and that simplify the presumptions. engage with the target company and other shareholders on issues through proxy First, it simplifies the total equity presumption solicitations. As discussed above, the rule so that a company will be presumed to control does include a presumption of control a second company only when the first related to soliciting proxies for the election company controls one-third or more of the of directors. total equity of the second company (i.e.,  No Presumption of Control for Threats to without regard to the first company’s voting Dispose of Securities: The Board securities ownership percentage). Under the traditionally has raised controlling influence proposal (and the Board’s 2008 Policy concerns if a company with control over 10 Statement), an investor with a voting interest percent or more of a class of voting of 15 percent or more in another company securities of a second company threatens to could avoid control only by keeping its total dispose of its investment if the second equity percentage in the other company company refuses to take some action below 25 percent. desired by the first company. The rule does Second, it simplifies the threshold for SLHCs. not include a presumption of control based Because of the difference between the BHCA on one company attempting to exercise and HOLA, the relevant total equity threshold control over another company by for SLHCs under the final rule will be 25 threatening to dispose of its voting or non- percent, not the one-third that applies to voting securities in the second company. BHCs.12 Passivity Commitments The rule also provides a more detailed description of the calculation of total equity. Historically, the Board has required passivity This is discussed in detail in the section below commitments from investors in banks or BHCs titled “Calculation of Total Equity.” with voting interest between 5 percent and 24.99 percent of any class of voting securities, Historical Presumptions of Control Not restricting the investor’s ability to have a Included in Final Rule controlling influence over the banking At least two factors that have historically organization. The Board’s standard passivity raised concerns of controlling influence were commitments usually included prohibitions or not included in the presumptions of control in limitations on (i) an investor's representation the rule. on the board of the banking organization, (ii) direct and indirect business relationships with  No Presumption of Control for the banking organization, (iii) management Solicitation of Proxies on Issues: The and employee interlocks, (iv) acquisition of Board historically has raised controlling additional equity of the banking organization, influence concerns if a company with and (v) serving as an investment or control over 10 percent or more of a class management adviser to the banking of voting securities of a second company organization. solicits proxies from the shareholders of the second company on any issue. The rule The Board stated that it does not intend to does not include a general presumption of continue obtaining the standard passivity

8 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules commitments in the ordinary course but will company serves as investment adviser to an continue to obtain control-related investment fund and controls 5 percent or commitments in specific contexts, such as more of any class of voting securities of the commitments from employee ownership fund or 25 percent or more of the total equity plans and mutual fund complexes, and in of the fund. The final rule did not adopt the special situations. It is unclear what the Board proposal’s limited exception for investment views as “special situations” or how “control- companies registered with the SEC under the related commitments” will differ from the Investment Company Act of 1940. standard passivity commitments. The presumption of control will not apply if Companies that have previously made the investment adviser organized and passivity commitments to the Board may sponsored the investment fund within the contact the Board or the appropriate Federal preceding twelve months. This provision Reserve Bank to seek relief from these allows the investment adviser to avoid commitments. Companies that have provided triggering the presumption of control over the commitments in connection with TARP investment fund during the initial seeding securities may also seek relief. Absent unusual period of the fund.14 Notwithstanding circumstances, the Board expects to be comments, the one-year seeding period in the receptive to such requests for relief. final rule does not align with the rules applicable to hedge fund and private equity STANDALONE PRESUMPTIONS OF fund investments under the Volcker Rule. CONTROL The rule includes several standalone The final rule also addressed two Board presumptions of control in addition to, and precedents related to investment advisers: separate from, the presumptions of control  Board Precedent Regarding Investments that comprise the tiered framework described in Advised Investment Funds: The above. proposal stated that the “proposed presumption of control for service as an Management Agreements investment adviser to an investment fund is The Board’s existing regulations include a intended to be consistent with the Board's presumption of control for management precedents regarding when an investment agreements under which a company can adviser controls an advised investment fund direct or exercise significant influence over the under the BHC Act and the Glass-Steagall management or operations of another Act.” The proposal cited a Board precedent company.13 The rule slightly expands the in which the Board concluded that, under existing management agreement presumption certain conditions, a company could provide by expressly identifying additional types of the initial capitalization to mutual funds that agreements or understandings that raise it advised and retain up to 25 percent of the controlling influence concerns, including voting securities after the initial agreements where a company is a managing capitalization period without being deemed member, trustee, or general partner of to control those funds.15 Many commenters another company. argued that the proposal’s 5 percent threshold was inconsistent with this Investment Advice and Investment Funds precedent and argued that the threshold The rule adds a presumption of control for should be raised to 25 percent. certain investment advisers of investment funds. The presumption applies where a

9 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules The final rule retains the proposal’s 5 presumptions of control in the rule, such as percent threshold. The Board described the the management agreement presumption. precedent as “an unusual case based in part While the rule is limited to the definition of on statutory provisions that are no longer in control in the Regulations Y and LL, the effect.” The Board noted that the threshold Board provided an interpretation of of 5 percent of any class of voting securities “ownership interest” under Regulation YY in “is consistent with the preponderance of the discussion of variable interest entities: Board precedent in this area.”16 In general, ownership interest  Board Precedent Regarding Mutual Fund under the intermediate holding Families: The final rule is silent on the company requirements does not status of certain control letters from the include contractual relationships, General Counsel of the Board to mutual including contractual relationships fund families and investments made in that result in consolidation of a accordance with those letters. However, the company under the variable issue appears to be addressed through the interest entity standard. Thus, for general statement that “the Board does not example, where a US branch of a intend to revisit existing structures that foreign bank has a contract with an were previously reviewed by the Federal -backed commercial paper Reserve System and have not changed conduit that causes the conduit to materially.” be consolidated by the branch under the variable interest entity Presumption of Control for Accounting standard, the contract is not an Consolidation ownership interest and therefore Despite significant concerns from may remain between the branch commenters, the final rule retains the and the conduit. presumption that a company that consolidates  Consolidation Under Non-GAAP a second company on its financial statements Standards: The presumption of control under US GAAP controls the second company. where one company consolidates a second This presumption is inconsistent with prior company for purposes of US GAAP covers, Board pronouncements and is likely to capture by its terms, only those companies that a number of arrangements previously prepare financial statements under US considered non-controlling. GAAP. The Board noted that it is likely to The final rule provides additional details have the same control concerns where a regarding how this presumption is to be company consolidates another company on applied. its financial statements under another  Variable Interest Entities: Under the rule, a accounting standard particularly if the other company that consolidates another accounting standard has consolidation company under the US GAAP variable standards that are similar to the interest entity standard is deemed to consolidation standards under US GAAP. control the second company. A company This arguably expands the consolidation that is consolidated under the variable presumption beyond US GAAP and may interest entity standard often will be require detailed ongoing analysis of how controlled under one of the other “similar” non-US accounting standards are to US GAAP.

10 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules  Equity Method of Accounting: The Presumption of Control for Combined proposal sought comment on whether the Ownership & Management (“5-25 Board should presume that a company Presumption”) controls a second company if the first The Board has historically applied a company applies the equity method of presumption, known as the “5-25 accounting with respect to its investment in presumption,” that a company controls a the second company. The final rule does second company when (i) the first company not adopt this presumption of control. controls at least 5 percent of any class of voting securities of the second company and Presumption of Control After Divestiture (ii) the senior management officials and The Board and Board staff historically have directors of the first company, together with taken the that a company that has their immediate family members and the first controlled another company may be able to company, own 25 percent or more of a class exert a controlling influence over that of voting securities of the second company. company even after a substantial divestiture The “5-25 presumption” has been integrated (the “tear down” rule).17 As a result, the Board into the final rule’s definition of “control over typically has applied a stricter standard for securities through associated individuals and terminating control than for establishing new subsidiaries.” This differs from the proposal, non-controlling investments.18 which included the “5-25 presumption” as a The rule substantially revises the Board’s standalone presumption. existing standards regarding divestiture of The presumption of control does not apply if control. Under the rule, a formerly controlling (i) the first company controls less than 15 company can escape presumed control by (i) percent of each class of voting securities of divesting to a voting interest of less than 15 the second company and (ii) the senior percent; or (ii) divesting to a voting interest of management officials and directors of the first less than 25 percent and waiting two years. company, together with their immediate The divestiture presumption does not apply if family members, control 50 percent or more a majority of each class of voting securities of of each class of voting securities of the second the second company is controlled by a single company. unaffiliated individual or company following divestiture. The exception only applies when Fiduciary Exception to Presumption of an unaffiliated person controls 50 percent or Control more of the outstanding securities of each The rule retains the existing Regulation Y class of voting securities of the company exception from the presumption of control for being divested. The divesting shareholder is securities held in a fiduciary capacity.19 Thus, only required to own a majority of the class of the presumptions of control do not apply to voting securities that the divesting the extent that a company controls voting or shareholder is selling, not a majority of nonvoting securities of a second company in a every class of voting securities of the fiduciary capacity without sole discretionary second company. authority to exercise the voting rights.

11 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules The rule does not provide broader clarity adopts these provisions with minor around the scope of the fiduciary exception. adjustments. The Board noted that the fiduciary exception in the final rule is intended to align with the First Company and Second Company Board’s traditional understanding of the scope The rule adds two new defined terms, “first of the fiduciary exceptions in the BHCA and company” and “second company,” to clarify Regulation Y and encourages companies to the application of presumptions of control. contact the Board or its staff to seek The final rule provides additional context on clarification as to whether a particular holding how the rule will apply to subsidiaries and of securities qualifies for the fiduciary joint ventures: exception.  Subsidiaries: For purposes of controlling REBUTTABLE PRESUMPTION OF influence, the Board historically has NON-CONTROL considered the relationships between one The rule also contains a presumption of non- company and its subsidiaries, on the one control for investments under 10 percent of hand, and another company and its voting securities that do not trigger any other subsidiaries, on the other hand. The Board presumption of control. confirmed that it will continue to group a parent company with its subsidiaries under Under the rule, a company is presumed not to the rule. control a second company if (i) the first  Joint Ventures: Any company that is both a company controls less than 10 percent of subsidiary of the first company and the every class of voting securities of the second second company is treated as a subsidiary company and (ii) no other presumptions of of the first company but not as a subsidiary control apply. This modestly expands the of the second company. This provision existing statutory and pre-existing regulatory prevents the second company’s presumption of non-control where the first relationships with a joint venture subsidiary company controls less than 5 percent of any with the first company from being class of voting securities of the second considered a relationship with the first company. company for purposes of the presumptions The filing requirements applicable to bank of control. holding companies and savings and loan holding companies for investments in 5 Control of Securities percent or more of any class of voting A person controls a security if the person securities of a company are not impacted as a owns the security or has the power to sell, result of the presumption of non-control, thus transfer, pledge, or otherwise dispose of the apparently continuing the gap between the security. In addition, a person controls a definition of control under the BHCA and the security if the person has the power to vote definition of control in the Board’s reporting the security, other than due to holding a forms (e.g., FR Y-10). -term, revocable proxy. These definitions are consistent with Board precedent and with OTHER CONTROL-RELATED DEFINITIONS 20 AND CALCULATIONS the language of the BHCA. The proposal defined several control-related The rule builds on these general statutory and items in a manner consistent with the Board’s regulatory definitions with additional tests for current practice but that previously have not determining whether a person “controls” been codified in regulation. The final rule

12 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules specific types of securities in specific subsidiary of the company. The Board circumstances.21 explained that a company generally should not be deemed to control securities held by  Control of Options, Warrants and a non-subsidiary of the company, and that Convertible Instruments (Look-Through the provision was removed to avoid the Approach): The final rule is generally creation of an expectation that a company consistent with the proposal with respect to would never be deemed to control these provisions. However, the final rule securities held by a non-subsidiary. includes an additional exception not included in the proposal that applies to  Control of a Percentage of a Class of preferred securities that have no voting Voting Securities: Determining the rights unless the issuer fails to pay percentage of a class of voting securities for six or more quarters. Such controlled by a person requires two securities are only considered to be voting calculations – one for the number of shares securities if a sufficient number of dividends of the class of voting securities controlled are missed and the voting rights are active. by the person, and another for the number This additional narrow exception to the of votes that may be cast by the person on look-through approach is consistent with the voting securities controlled by the Board precedent and helps to address a person. Determination of the percentage of common feature of preferred securities. a class of a company’s voting securities Securities with springing voting rights that controlled by the person will be based on do not fit into this exception generally will the greater of the results of the two be considered to be voting securities under calculations. the look-through approach.  Reservation of Authority: The Board  Control Over Securities Through reserves the authority to determine that Restrictions on Rights: Consistent with securities that would otherwise be current regulations, the rule provides that a considered controlled or not controlled by a person controls securities if the person is a person are actually controlled or not party to an agreement or understanding controlled by that person. under which the rights of the owner or holder of securities are restricted in any Calculation of Total Equity Percentage manner, unless the restriction falls under The final rule’s GAAP-based core one of six exceptions specified in the rule. methodology for determining a company’s This standard could result in multiple total equity percentage in another company is persons being considered to have control largely consistent with the proposal. The final over the same securities. rule includes a technical correction to the  Control of Securities by Non-Subsidiary: formula for total equity so that pari passu The proposal provided that a person classes of (i.e., classes of controls all voting securities controlled by preferred securities of the same seniority in any subsidiary of the person, and that a liquidation) are treated as a single class. Key person generally does not control any provisions of the rule’s methodology include: voting securities controlled by any non-  Treatment of Debt as Equity: The rule subsidiary of the person. The final rule does includes a provision whereby debt or other not include the express statement from the interests may be treated as equity if the proposal that a company does not control interests are functionally equivalent to securities that are controlled by a non- equity. The Board expects to reclassify debt

13 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules as equity under the rule only under LL for SLHCs in essentially the same manner as unusual circumstances to prevent evasion into the Board’s Regulation Y for BHCs. of the rule. However, as noted below in the discussion of  Flexibility for Excluding Nominally Equity total equity calculations, minor differences in Instruments From Total Equity if their respective statutory authorities required Functionally Equivalent to Debt: The rule a revision in the final rule to reflect that provides flexibility for excluding nominally contributed capital for purposes of HOLA equity instruments from total equity if the generally has the same meaning as total equity instruments are determined to be equity as used by the Board in the context of functionally equivalent to debt. The rule control under the BHCA. Other than the also provides a non-exclusive list of provisions related to total equity, the final rule characteristics that may indicate that an creates an essentially consistent control equity instrument is functionally equivalent framework between Regulation Y and to debt, including: protections generally Regulation LL. provided to creditors; a limited term; a fixed The rule does not include any presumptions or or a variable rate of return exclusions specially tailored to the non-US linked to a reference interest rate; operations of FBOs, nor does it modify the classification as debt for tax purposes; or Board’s Regulation K. In response to several classification as debt for accounting comments expressing concern that certain of purposes. This provision is intended to the presumptions could have extraterritorial provide flexibility for unusual structures and reach by attributing control over companies is expected to be used rarely. Companies outside the United States, especially by FBOs, are encouraged to consult with the Board or and requests for clarification that lawful home its staff in order to determine whether country activities and relationships currently equity instruments would be excluded from in existence should not be upset by the total equity. proposal, the Board noted that the  Change Regarding Recalculation of Total statutory framework for control does not Equity on Sale or Divestiture: The final contemplate different definitions of control for rule is narrower than the proposal in that it companies in different jurisdictions. The Board requires calculation of total equity only characterized the rule as “generally consistent when a first company acquires control over with the Board’s current practice,” stating that additional equity of a second company. The it does not expect the final rule to “result in first company is not required to recalculate substantially different outcomes for its total equity when it sells or otherwise questions of controlling influence involving disposes of equity of the second company. foreign companies.” This change will prevent a divestiture from causing an increase in total equity due to INTERACTION WITH OTHER REGULATIONS changes at the second company. The rule is intended to apply to questions of control under the BHCA and HOLA. Section APPLICATION TO SLHCS AND FBOS 4(c)(6) of the BHCA permits BHCs to invest in The rule applies equally to BHCs and SLHCs to up to 5 percent of the voting shares of any the maximum extent permitted by law. company, but these investments must be Consistent with this principle, the rule passive or non-controlling. As a result, the incorporates the control presumptions and control framework in the rule applies for related revisions into the Board’s Regulation purposes of section 4(c)(6) and, in particular,

14 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules the Board’s interpretation of section 4(c)(6) interprets the definition of ownership interest located in section 225.137 of the Board’s in Regulation YY in relation to asset-backed Regulation Y. commercial paper conduits. Notwithstanding extensive support from industry, the final rule does not extend to or For more information about the topics raised in modify the concepts of control under the this Legal Update, please contact any of the Change in Bank Control Act22 or the Board’s following lawyers. Regulation O23 and Regulation W.24 In her short statement accompanying the final rule, Thomas J. Delaney Federal Reserve Board Governor Brainard +1 202 263 3216 made specific note of the importance of [email protected] monitoring “how the control framework Jeffrey P. Taft interacts with other regulations that involve +1 202 263 3293 ownership thresholds in order to ensure the [email protected] different elements of the Board's regulatory framework in totality are functioning as Matthew Bisanz intended and to identify and address any +1 202 263 3434 inconsistencies, as appropriate.” The Board [email protected] stated that it may in the future consider Logan S. Payne conforming revisions to these other elements +1 202 263 3268 of its regulatory framework. [email protected] The rule also does not explicitly modify Regulation YY but, as discussed above,

Endnotes

1 Board, Federal Reserve finalizes rule to simplify and increase 6 Board Staff Memorandum (April 16, 2019), available at the transparency of the Board’s rules for determining control https://www.federalreserve.gov/aboutthefed/boardmeetin of a banking organization (Jan. 30, 2020), available at gs/files/control-proposal-board-memo-20190423.pdf. https://www.federalreserve.gov/newsevents/pressreleases/ 7 While the final rule makes minor modifications to the bcreg20200130a.htm. formal procedures for determining control, there is no 2 84 Fed. Reg. 21634 (May 14, 2019). indication that the Board intends to rely exclusively on 3 12 U.S.C. §§ 1841(a)(2) and 1467a(a)(2). formal control proceedings. 8 4 12 U.S.C. §§ 1843 and 1467a(c). Opening Statement on Proposal to Revise the Board’s Control Rules by Vice Chair for Supervision Randal K. 5 The three-pronged test for “control” is the BHCA test. 12 Quarles (April 23, 2019), available at U.S.C. § 1841(a)(2); 12 C.F.R. § 225.2(e) (all citations are to https://www.federalreserve.gov/newsevents/pressreleases/ the Code of Federal Regulations prior to the amendments quarles-opening-statement-20190423.htm. made by this final rule). The definition of control in HOLA 9 is substantially similar. See 12 U.S.C. § 1467a(a)(2); 12 C.F.R. The final rule does not provide a rubric for Board staff to § 238.2(e). As discussed further below, one difference examine qualitative characteristics in a consistent manner between the BHCA and HOLA is that the definition of beyond a statement that significant relationships may control under HOLA includes situations where a company include those that are difficult to replace and are necessary has contributed more than 25 percent of the capital of for core functions. The final rule also does not appear to another company. limit this expansive footnote to the tiered framework, potentially putting at risk investments held under section 4(c)(6) of the BHCA. See e.g., FRB Ltr. of Mar. 4, 1996

15 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules (recognizing a controlling influence without control of any rebuttable presumption that a transferor continued to voting securities). control securities of a company transferred to a transferee if the transferee was indebted to the transferor or if there 10 Examples of persons who would be considered to be were certain director or officer interlocks between the director representatives include (i) individuals who are transferor and transferee. The 2(g)(3) policy statement officers, employees, or directors of the first company, (ii) remains relevant because it reflects the Board’s individuals who were officers, employees, or directors of longstanding position that terminating control requires the first company within the preceding two years, and (iii) reducing relationships to lower levels than would be individuals who were nominated or proposed by the first consistent with a new non-controlling relationship. company to be directors of the second company. 19 See 12 C.F.R. § 225.31(d)(2)(iv); see also 12 U.S.C. § 11 The final rule also clarifies that the quantitative thresholds 1841(a)(5)(A). are based on total consolidated annual revenues and expenses as these terms are commonly understood in the 20 See, e.g., 12 U.S.C. §§ 1841(a)(2)-(3) and 1842(a). context of US generally accepted accounting principles 21 These standards effectively replace the presumptions for (“GAAP”), and that revenue is understood to mean gross control over voting securities currently in 12 C.F.R. § income, not income net of expenses. Principles of 225.31(d)(1). In this discussion, “person” has the meaning consolidation are also meant to be applied as generally provided in 12 C.F.R. § 225.2(l) and 12 C.F.R. § 238.2(j). implemented in the context of GAAP. 22 12 U.S.C. § 1817(j). 12 Because of a unique “25 percent of contributed capital” 23 12 C.F.R. pt. 215. The analysis conducted in the context of prong in the HOLA definition of control, the proposal the proposal identified issues under Regulation O and included a “total equity” presumption of control in resulted in the US banking regulators issuing temporary addition to the “contributed capital” statutory standard of no-action relief in late-2019. See Board, SR 19-16 (Dec. 27, control for savings and loan holding companies. The final 2019). rule does not include a presumption of control based on 24 12 C.F.R. pt. 223. total equity for savings and loan holding companies. Instead, the preamble to the final rule states that

contributed capital under HOLA generally means the same Mayer Brown is a distinctively global law firm, uniquely positioned to advise the thing as total equity in the Board’s regulations world’s leading companies and financial institutions on their most complex implementing the BHCA. Accordingly, the relevant total deals and disputes. With extensive reach across four continents, we are the only integrated law firm in the world with approximately 200 lawyers in each of the equity threshold for SLHCs under the final rule will be 25 world’s three largest financial centers—New York, London and Hong Kong— percent, not the one-third that applies to BHCs. This is the backbone of the global economy. We have deep experience in high-stakes litigation and complex transactions across industry sectors, including our consistent with precedents interpreting contributed capital signature strength, the global financial services industry. Our diverse teams of under HOLA. lawyers are recognized by our clients as strategic partners with deep commercial instincts and a commitment to creatively anticipating their needs 13 See 12 C.F.R. §§ 225.31(d)(2)(i), 238.21(d)(2)(i). and delivering excellence in everything we do. Our “one-firm” culture— 14 The proposed presumption of control for serving as an seamless and integrated across all practices and regions—ensures that our clients receive the best of our knowledge and experience. investment adviser to an investment fund was intended to Please visit mayerbrown.com for comprehensive contact information for be consistent with the Board’s precedents regarding when all Mayer Brown offices. an investment adviser controls an advised investment fund Any tax advice expressed above by Mayer Brown LLP was not intended or written under the BHCA. to be used, and cannot be used, by any taxpayer to avoid U.S. federal tax penalties. If such advice was written or used to support the promotion or marketing 15 See Letter to H. Rodgin Cohen, Esq., dated June 24, 1999, of the matter addressed above, then each offeree should seek advice from an independent tax advisor. available at https://www.federalreserve.gov/boarddocs/ This Mayer Brown publication provides information and comments on legal legalint/BHC_ChangeInControl/1999/19990624/. issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended 16 Final Rule at 43. to provide legal advice. Readers should seek legal advice before taking any action with respect to the matters discussed herein. 17 See, e.g., 12 C.F.R. § 225.138. The divestiture policy Mayer Brown is a global services provider comprising associated legal practices statement indicates that divestiture is a special that are separate entities, including Mayer Brown LLP (Illinois, USA), Mayer Brown consideration for purposes of control and that the Board’s International LLP (England), Mayer Brown (a Hong Kong partnership) and Tauil & Chequer Advogados (a Brazilian law partnership) (collectively the “Mayer Brown normal rules and presumptions regarding control may not Practices”) and non-legal service providers, which provide consultancy services always be appropriate in the context of divestiture. (the “Mayer Brown Consultancies”). The Mayer Brown Practices and Mayer Brown Consultancies are established in various jurisdictions and may be a legal person 18 See, e.g., 12 C.F.R. § 225.139 (“2(g)(3) policy statement”). or a partnership. Details of the individual Mayer Brown Practices and Mayer Brown Consultancies can be found in the Legal Notices section of our website. The 2(g)(3) policy statement describes the implementation “Mayer Brown” and the Mayer Brown logo are the trademarks of Mayer Brown. of section 2(g)(3) of the BHCA (Congress removed section © 2020 Mayer Brown. All rights reserved. 2(g)(3) from the BHCA in 1996). Section 2(g)(3) created a

16 Mayer Brown | US Federal Reserve Board Approves Final Rule Significantly Revising Control Rules