Oct 01, 2020

Federal Reserve Releases FAQs on Select “Control” Issues

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FEDERAL RESERVE RELEASES FAQS ON SELECT “CONTROL” ISSUES

The Federal Reserve has released FAQs covering its recently revised control regulation, which became effective on September 30, 2020 (the “Control Rule”).[1] For more on the specifics of the Control Rule, please refer to our previous client note, Federal Reserve Board Adopts Final Control Regulation. The FAQs address industry questions concerning:

  • the calculation of “Issuer Shareholders’ Equity” when determining total equity under the Control Rule;
  • potential “grandfathering” of certain existing investments; and
  • limiting contractual rights, including covenants in loan agreements, as an indication of control.

Calculation of Issuer Shareholders’ Equity

Under the Control Rule, a first company is presumed to control a second company if the first company controls one-third or more of the second company’s total equity. In the FAQs, the Federal Reserve clarified the methodology by which it would calculate “Issuer Shareholders’ Equity,” which serves as the denominator under the total equity calculation. As set forth in the Control Rule, a first company’s total equity in a second company is equal to the sum of the first company’s Investor Common Equity and, for each class of preferred stock issued by the second company, Investor Preferred Equity, divided by Issuer Shareholders’ Equity.

  • Investor Common Equity. The FAQs explain that Investor Common Equity is the share of the second company’s common stock controlled by the first company multiplied by the amount of the second company’s balance sheet shareholders’ equity under U.S. GAAP that is not allocated to preferred stock.
  • Investor Preferred Equity. Likewise, Investor Preferred Equity is, for each class of preferred stock issued by the second company, the share of the class of preferred stock controlled by the first company multiplied by the amount of the second company’s balance sheet shareholders’ equity under U.S. GAAP that is allocated to the class of preferred stock.
  • Investor Shareholders’ Equity. Accordingly, Issuer Shareholders’ Equity is the sum of Investor Common Equity and Investor Preferred Equity for each person that controls equity instruments of the second company.

The Federal Reserve explained that as the numerator and the denominator used to determine a first company’s total equity ownership of a second company are both calculated in a consistent manner based on U.S. GAAP under the above approach, a first company that controls less than one-third of each class of equity securities of a second company should always control less than one-third of the total equity of the second company (emphasis added).

This calculation and clarification addresses concerns that were raised in the implementation period regarding the potential impact of negative retained earnings on the calculation of Issuer Shareholders’ Equity.

Clarifications Regarding Existing Investments

In response to questions regarding the impact of the Control Rule on investments that predate the effective date of the Control Rule, i.e., September 30, 2020, the Federal Reserve stated that staff would not require parties to alter investment structures that represented “a reasonable interpretation of Board precedent at the time the structure was created.” Nevertheless, the FAQs note that investors may consult the Federal Reserve’s staff concerning any investments made or relationships entered into that trigger a presumption of control under the Control Rule to discuss what, if any, alterations should be made to continue to treat the structure as noncontrolling (emphasis added).

Limiting Contractual Rights

Bank Holding Company Act (“BHCA”) Activities Restrictions. The FAQs state that a contractual right of one company to force another to conform its activities to those permitted under the BHCA or the Home Owners’ Loan Act (“HOLA”) generally would be considered a limiting contractual right under the Control Rule, since the first company would hold a right to limit the ability of the second company to engage in new lines of business. The FAQs clarify, however, that a contractual right to redeem, reduce or restructure an investment in another company if the second company fails to conform its activities to the activities restrictions of the BHCA or HOLA generally would not be considered a “limiting contractual right” under the Control Rule. The mechanism afforded by such a right must, however, be “reasonable and non-punitive.”

Market Standard Loan Covenants as Limiting Contractual Rights. In response to inquiries, the Federal Reserve stood firm that there is no exception from the definition of limiting contractual rights for covenants in loan agreements. Specifically, the FAQs note that the Control Rule “does not differentiate between limiting contractual rights based on the circumstances under which the right was created or the nature of the document in which the right resides.” Instead, the Federal Reserve focused on the fact that the loan covenants would only become a trigger for control if it were combined with ownership of 5% or more of any class of voting securities of the second company.

We are happy to discuss these FAQs and the Control Rule in general should you have any questions.

Footnotes

[1] 12 CFR Parts 225 and 238.

Autoren und Mitwirkende

Reena Agrawal Sahni

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7324

+1 212 848 7324

New York

Mark Chorazak

Partner

Financial Institutions Advisory & Financial Regulatory

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+1 212 848 7100

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Timothy J. Byrne

Counsel

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7476

+1 212 848 7476

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Le-el Sinai

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7550

+1 212 848 7550

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Caitlin Hutchinson Maddox

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5294

+1 212 848 5294

New York