One of the obstacles in bank-related private equity investing relates to whether the investment, and the participation with the organization, triggers “control” of a banking organization under applicable state or federal law and regulation.

If so, the investing organization stands to risk being subject to the restrictions on operations and activities of a “bank holding company” (“BHC”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”) and applicable Federal Reserve regulations; being subject to Fed oversight, examination and capital requirements; being subject to the Fed’s “source of strength” doctrine and the cross-guaranty provisions of FDICIA; and a variety of other legal and regulatory issues including agency enforcement exposure. In addition, issues arise under various provisions of the federal “Change in Bank Control Act” (“CBCA”) and state laws regarding changes in control of state banking organizations.

The consequences of “controlling” a bank are significant, not always obvious to those who have not been exposed to the issues previously and require careful consideration as to potential investor liability issues and structuring alternatives before proceeding.

A recent Federal Reserve issuance intended to enhance private equity investment in banking organizations by expanding opportunities for greater participation in both the amount of the financial investment and director involvement should help to encourage private equity participation. However, the consequences and risks of “control” remain, and care must be taken to understand the risk and implement appropriate structural safeguards, to the extent that they are available, to mitigate the potential impact.

“Control” and the Consequences of “Control” of a Bank or BHC

Bank Holding Company Act (“BHCA”)

The Fed defines “control” through the BHCA and relevant regulations which also reserve significant subjective authority to the Fed to combine roles (such as ownership, board seats, acting in concert, etc.) to determine “control” despite legal structural barriers and technical “control” definitions. While those restrictions have been loosened, for practical purposes the Fed retains extensive authority to make “control” determinations subject to appeal.

In addition, while the BHCA applies to organizational investors and not individuals, the Fed may combine investors acting in concert to determine the existence of a “company.” Individual investors continue to be subject to other related state and federal laws as noted below.

As a BHC, an investing organization is subject to regular examination as well as risk-based capital adequacy requirements on a consolidated basis. It is also limited to activities and investments eligible for a BHC or Financial Holding Company under the BHCA. Investors can sometimes limit the impact by using separate funds for the sole purpose of holding a particular financial services investment but that only works if sufficient special legal separations are put in place to ensure that the control and operation of the fund are effectively partitioned from other funds sponsored by the same PE firm that hold investments in non-financial businesses. Investors should expect regulatory scrutiny and suspicion.

Becoming a BHC also entails undertaking an extensive Fed application process and securing Fed approval prior to exercising “control.”

Change in Bank Control Act (“CBCA”)

“Control” under the CBCA is more broadly defined and includes individuals. It too requires a detailed application process (including extensive background and financial information on investors) and prior approval of applicable federal banking agency prior to exercising “control” of an institution.

There are also state “change in bank control” laws and regulations that must be taken into consideration for both banks and bank holding companies, depending on the chartering state.

Important Consequences of “Control”

The Fed’s “Source of Strength” doctrine provides potentially unlimited holding company responsibility and liability for losses incurred by an acquired bank. That doctrine anticipates that a BHC will inject capital as needed into bank subsidiary organizations irrespective of investor reluctance.

The cross-guarantee provisions of FIRREA provide generally that insured depositories are liable for losses incurred by FDIC in “commonly controlled” institutions, thus making banking organizations controlled by the same holding company subject to providing capital support for sister organizations. This can be particularly problematic for PE funds that may invest in multiple banks if the fund “controls” the banks.

Capital restoration plans for troubled institutions under FDICIA are required to provide that companies that “control” undercapitalized banks subject to a FDICIA capital restoration plan must guarantee that the bank will comply with the plan. The impact on investors at the holding company level is obvious and can provide unlimited liability for further capital investment.  

There is potentially unlimited liability for individuals and organizations that “control” a bank or banks, and from a practical perspective, agency enforcement authority can be used to reach through corporate and other organizational structures should the agency decide to do so. There is also significant subjective latitude for the Fed to undertake “control” determinations which may be costly and time-consuming to contest. Therefore, it is critical that investors take care in structuring private equity investments to avoid inadvertent control issues and liability if possible.

Institution-Affiliated Party Status (“IAP”) and Agency Enforcement Actions

Since its enactment in 1989, FIRREA has expanded the panoply of possible regulatory enforcement action proceedings with respect to “institution-affiliated parties” (“IAP’s”). IAP’s include officers, directors, employees, principal/controlling shareholders (and others in “control”) as well as independent contractors (such as lawyers, appraisers, accountants, consultants, etc) who participate in the affairs of an institution. Enforcement actions can include liability for civil money penalties which can exceed $1 million per day, asset freezes, forced equity contributions and a variety of other agency enforcement tools. Being subject to such enforcement actions involves potentially unlimited personal liability for IAP’s which is not typically covered by corporate indemnification, D&O insurance or other insurance policies.

As a practical matter, enforcement proceedings are extremely difficult, costly and time-consuming to contest, and courts nearly always defer to agency discretion. Much traditional procedural “due process” was eliminated by FIRREA, and IAP’s are subject to agency jurisdiction for enforcement purposes for years following termination of IAP status. Given the issues and current industry environment, Congress and the new administration may well place increased pressure on agencies which may result in an even tougher agency stand on IAP enforcement actions.

Conclusions

While opportunities for PE investment in banking institutions have been enhanced, as always the devil is in the details and care should be taken in structuring the relationship so as to minimize potentially adverse “control” issues for the investor when appropriate. Some bank PE investors have little or no in-depth experience in the banking industry and may be unaware of the potential liability issues that may accompany bank investment relationships in certain circumstances. Then again, some of the issues are simply an inescapable part of doing business in the banking industry. In any event, entering the relationship with eyes open can help avoid later surprises.