Spurred on by a notable increase in bank failures this year (89 to date) and the resultant decrease in the size of the Federal Deposit Insurance Fund ("Fund") available to resolve new bank failures ($10.4 billion as of June 30, 2009), the FDIC, on Aug. 26, 2009—a mere 48 days after coming out with its proposal—adopted its final Statement of Policy on the Acquisition of Failed Depository Institutions ("SOP"). The FDIC now has 416 banks on its problem list, an increase of 111 from March 31. The SOP seeks to encourage private capital investors ("Investors") to acquire the deposits or the deposits and assets of failed banks and thrifts ("Banks"), while at the same time imposing limitations and restrictions to reduce the additional risks that these Investors, who are new entrants to the banking industry, are thought to bring with them. Some questions and answers about this new SOP are set forth below.
Please click the following link to view the FDIC's Final Statement of Policy www.fdic.gov/news/news/press/2009/pr09152.html
1. To whom does the SOP apply?
Answer: The FDIC is intentionally vague in this regard. While the FDIC states that the SOP is "just that – a policy statement and not a statutory provision imposing civil or criminal penalties" that is applicable only to investors that agree to its terms, it goes on to say that it finds it "exceedingly difficult to use precisely defined terms to deal with the relatively new phenomenon of private capital funds joining together to purchase the assets and liabilities of failed [Banks] where the investors all are less than 24.9 percent owners but supply almost all of the capital to capitalize the new depository institution." Accordingly, it decided to leave the term somewhat imprecise.
"Investors" are thus defined in the SOP as private investors in a company that is proposing to acquire (or to bid to acquire), including through a shelf charter, the deposits or the deposits and assets of failed Banks, and applicants for FDIC insurance for de novo charters issued in connection with the resolution of failed Banks.
2. To whom doesn't the SOP apply?
Answer: On this issue, the FDIC was precise. First, the SOP does not apply, retroactively, to Investors whose acquisitions of deposits or deposits and liabilities of failed Banks were completed before the approval date of the SOP. Second, it does not apply to Investors in partnerships or similar ventures with Bank holding companies (other than shell companies), where the holding company partner has a strong majority interest in the resulting Bank and an established record of successful operation of Banks. Third, it excludes Investors who do not possess more than 5 percent of the total voting power of an acquired Bank or its holding company, and as to whom there is no evidence of concerted action with other Investors.
3. When does it cease applying?
Answer: The SOP ceases to apply to an Investor when the resulting Bank has maintained a composite Camels rating of 1 or 2 continuously for seven years. The FDIC does not indicate, however, whether this seven-year period begins to run when the resulting bank is acquired or when the resulting bank receives its initial Camels 1 or 2 rating. It also does not indicate how it will apply to an Investor in an existing Bank that is in possession of a current Camels rating of 1 or 2 when it acquires a failed Bank.
4. Does the SOP allow for any flexibility?
Answer: Yes. The FDIC may waive one or more of its provisions if it deems such a waiver to be in the best interests of the Fund, and if it believes that the objectives of the SOP can be met by other means.
5. Does the SOP replace requirements imposed by the relevant federal bank or thrift regulator, or bank or thrift holding company regulator, under applicable laws and regulations, or with respect to any determinations made or requirements imposed regarding the general character, fitness and expertise of proposed management, acceptable business plans, corporate governance structures, representations, and any other supervisory matters?
Answer: No. Investors must still fulfill all such requirements.
6. What initial capital requirements must Investors meet to qualify to purchase a failed Bank?
Answer: Investors must commit to provide a level of initial capitalization sufficient to establish a ratio of Tier 1 common equity (Tier 1 capital less non-common equity elements) to total assets of at least 10 percent throughout the first three years. The FDIC had initially proposed a more robust capital requirement (a Tier 1 leverage ratio of at least 15 percent), but backed off out of concern that it would unduly discourage private capital investment in failed Banks to the detriment of the Fund. (Still, perhaps worried that the 10 percent Tier 1 common equity-to-total assets ratio may be insufficient in certain cases, the FDIC indicated in the preamble to the SOP that it can increase that level "if warranted.")
7. What happens after three years?
Answer: After three years and for as long as the Investors' ownership of the Bank continues, the Bank must remain "well capitalized."
8. What happens if the Bank fails to meet the initial 10 percent Tier 1 common equity-to-total assets ratio during the first three years, or fails thereafter to be "well capitalized"?
Answer: The Bank would be required to take immediate action to restore capital to the required level. If it is unable to do so, it will be treated as "undercapitalized" and therefore be subject to "Prompt Corrective Action" and other supervisory measures by its primary regulator.
9. Must Investors agree to serve as a "source of strength" for subsidiary Banks?
Answer: No. Although the FDIC had originally proposed to impose the "source of strength" provision, the FDIC deleted that requirement from the SOP, apparently having been convinced by commenters that such a requirement would not be feasible as a practical matter. The commenters on this issue pointed out that many Investors are limited by the terms of their fund documents from providing capital support or making follow-on investments in their portfolio companies.
10. Must Investors provide "cross guarantees" of their individual or collective investments comprising a majority interest in multiple Banks to cover losses to the Fund caused by the failure of any one of those Banks?
Answer: No. Whereas the original proposal would have required one or more Investors having majority interests in two or more Banks to pledge their interests in each Bank to the FDIC to cover losses to the Fund based on the failure of any of such Banks, the SOP limits its new "cross support" requirement to where one or more Investors owns at least 80 percent of two or more Banks. Such an Investor or Investors must then pledge to the FDIC their commonly owned stock in these Banks. If any one of the Banks should fail, the FDIC would be entitled to exercise these pledges as necessary to recoup any losses incurred as a result of such failure. This may be waived by the FDIC where its exercise would not decrease the cost to the Fund.
TRANSACTIONS WITH AFFILIATES
11. May failed Banks acquired by Investors under the SOP extend credit to Investors, their investment funds if any, or any affiliates of either?
Answer: No. All such transactions are prohibited. For purposes of this provision, the term "affiliate" is defined as any company in which the Investor owns, directly or indirectly and for at least 30 days, at least 10 percent of its equity, and "extension of credit" is given the same definition as in Regulation W (12 C.F.R. 223.3(o)). Investors must regularly identify all such affiliates to the Bank. Existing extensions of credit by a failed Bank acquired by Investors are not affected by this prohibition.
USE OF OFFSHORE ENTITIES AS INVESTMENT VEHICLES
12. May Investors use offshore funding structures that provide tax and other efficiencies to make investments in failed Banks?
Answer: No. Investors with ownership structures that include offshore entities domiciled in "Secrecy Law Jurisdictions" are prohibited from acquiring a failed Bank.
13. Are there any exceptions to this prohibition?
Answer: Only one, and it is a very narrow one. An Investor with an ownership structure that includes an offshore entity domiciled in a "Secrecy Law Jurisdiction" may acquire a failed Bank only if it meets all of the following requirements: (1) It is a subsidiary of a company that is subject to "Comprehensive Consolidated Supervision" as recognized by the Federal Reserve Board; (2) it executes an agreement concerning the provision of information to the primary federal regulator about its non-domestic operations and activities; (3) it maintains its business books and records in the United States; (4) it consents to the disclosure of information that might be covered by confidentiality or privacy laws, and agrees to cooperate with the FDIC, if necessary, in obtaining information from foreign government entities; (5) it consents to jurisdiction and designation of an agent for service of process; and (6) it consents to be bound by the laws and regulations administered by the appropriate federal banking agency.
14. What is a "Secrecy Law Jurisdiction"?
Answer: A "Secrecy Law Jurisdiction" is a country that applies a bank secrecy law that limits U.S. bank regulators from determining compliance with U.S. laws, prevents them from obtaining critical information concerning applicants and related parties, does not provide authority to exchange information with U.S. regulators, does not provide for a minimum standard of transparency for financial activities, or permits offshore companies to operate shell companies without substantial activities within the host country.
CONTINUITY OF OWNERSHIP
15. Are there limits on an Investor's ability to sell or otherwise transfer its interest in a failed Bank that it has acquired under this SOP?
Answer: Yes. Believing that long-term investments are important to stabilize the operations of a failed Bank, the FDIC has decided to prohibit Investors from disposing of their ownership interests in failed Banks for at least three years following the acquisition absent the FDIC's prior approval. However, if the transfer is to an affiliate, the FDIC indicates that it will not unreasonably withhold approval so long as the affiliate agrees to be subject to all of the conditions that are applicable to the transferring Investor under this SOP. Mutual funds that issue redeemable securities that allow investors to redeem on demand are excluded from this three-year restriction.
16. Are there certain structures that are not eligible under the SOP to bid on failed Banks?
Answer: Yes. The FDIC will not accept bids from "complex and functionally opaque ownership structures" in which the beneficial owners and responsible decision-making parties are difficult to ascertain or identify, and ownership and control are separated. The FDIC believes such structures are typified by organizational arrangements involving a single private equity fund or fund sponsor that seeks to acquire a Bank through the creation of multiple investment vehicles, all funded and apparently controlled by the parent fund or fund sponsor. The FDIC believes that such structures are designed to avoid requirements that the fund become a Bank or Bank holding company, and raise serious concerns about the sufficiency of financial and managerial support to the acquired Bank.
17. Can Investors who currently own an interest in a failed Bank bid to acquire the deposits or the deposits and liabilities of the failed Bank?
Answer: If such Investors own, directly or indirectly, 10 percent or more of the equity of the failed Bank, they are not eligible to be a bidder to become an Investor in the deposit liabilities, or the deposit liabilities and assets, of that failed Bank.
18. What information must Investors submit to the FDIC when seeking approval to acquire a failed Bank?
Answer: Disclosure requirements under the SOP are extensive. Investors must provide the FDIC with information concerning the Investors and all entities in the ownership chain, including the capital fund or funds' size, diversification, return profile, marketing documents, management team, and business model, and "such other information as is determined to be necessary to assure compliance with this [SOP]." Confidential business information will be kept confidential by the FDIC and not disclosed except in accordance with law.
- Whether the FDIC has achieved the right balance in this SOP remains to be seen. Even the FDIC is not sure. It indicates in the SOP that it will review its operation and impact in six months to figure out whether any adjustments are necessary, and make those adjustments.
- To the extent the SOP requires Investors to have more capital than would be expected for the traditional banks and their holding companies, it is a discouraging sign for such Investors and the expectation of returns for them and their investors. This will significantly reduce the attractiveness of such investments to these Investors, and cut off or limit a source of capital that is needed at this time.
- The initial demand by the FDIC that Investors provide significantly more capital (three times the high-end leverage range and double the industry average) than is required for "well capitalized" institutions was not sustainable, although banks in operation for less than seven years are overrepresented in the list of institutions that have failed in 2008 and 2009. At the same time, the Treasury Department's Sept. 3 announcement of a Policy Statement establishing a set of principles to guide reforms to the global regulatory capital and liquidity framework (discussed further here), suggests the FDIC anticipated stricter capital rules going forward.