The manner by which the agencies that oversee U.S. financial institutions regulate private equity investment in the banking business profoundly affects the ability of failing banks to attract capital, avoid taxpayer bailouts and minimize losses to the Deposit Insurance Fund. However, private investors that have sought to structure non-controlling investments in failing banks may feel like they are not welcome to assist failing banks after the Federal Deposit Insurance Corporation recently proposed and adopted a policy statement regarding investments in failed banks. While the FDIC’s final Statement of Policy dialed back certain proposals that were likely to significantly dampen private equity interest in troubled financial institutions, other aspects of the Statement will put private equity investors at a significant disadvantage to other potential investors when considering such investments.

The FDIC Policy Statement

In July 2009, the FDIC proposed a policy statement identifying certain core concerns with respect to private equity investment in failing institutions. While the proposal singled out private equity investments for increased scrutiny and regulation, it did not explain why banks owned by passive private equity investors posed greater risks to the Deposit Insurance Fund than institutions controlled by traditional publicly-traded shell holding companies. Despite significant criticism, the FDIC moved quickly to adopt the final Statement on August 26, 2009. While the Statement continues to single out private equity investors, the FDIC moderated a few of the most troublesome aspects of its initial proposal.

On December 11, 2009, the FDIC issued a set of interpretive FAQs, which it withdrew twentyfour hours later for reasons that were not made public. On January 10, 2010, the FDIC rereleased the FAQs, which essentially address situations where certain interests of private investors in failed bank transactions would be exempt from the policy statement. Specifically, in order for a joint venture of private investors with an established banking organization to be exempt, the banking organization (or, in certain circumstances, its shareholders) must hold at least two-thirds of both voting and total equity of the investment vehicle. The FAQs also suggest that private equity investors may be found to be engaged in “concerted action” under circumstances not covered by other control regulations, which raises additional questions.

Applicability

The Statement does not apply to “private investors” that own 5% or less of the total voting power of an acquired bank or its holding company, provided that there is no evidence of concerted action by investors. In contrast, the Board of Governors of the Federal Reserve System (FRB), the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) generally trigger their control analyses at 10% of the voting stock of a bank or its holding company.

The term “private investor” is not defined and the FDIC has reserved to itself significant discretion to determine when the Statement applies. Investors can apply to terminate the application of the Statement if the covered institution has continuously received one of the top two composite ratings for safety and soundness for seven years.

In contrast, the Statement does not apply to, and strongly encourages, partnerships or joint ventures between private equity investors and established bank or thrift holding companies in which the holding company has a “strong majority interest” in the resulting bank or thrift. This may create the opportunity for private equity investors with an appetite for making noncontrol investments to make significant investments in existing banks that would then take advantage of federal assistance to acquire troubled depositary institutions.

Capital Requirements  

The Statement establishes independent capital requirements in addition to those already established by the FRB, OCC and OTS for bank holding companies, national banks and savings associations, respectively. Specifically, covered institutions must maintain a minimum ratio of common equity to total assets of 10% for three years, approximately double what a strategic buyer would be required to do. Under the initial proposal, such banks would have been required to maintain at least a 15% ratio of Tier 1 capital to total assets (which would have included perpetual preferred stock and other non-common-equity elements which cannot be taken into account under the Statement).

After three years, the new or acquired institution must maintain capital ratios sufficient to qualify as “well capitalized” under the prompt corrective action (PCA) provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991. There is no express requirement for private investors to contribute additional capital to the institution, though current investors could face substantial dilution if the institution is compelled to raise capital from new investors in order to meet “well capitalized” standards.

If the bank falls below the required capital ratio, it (not the holding company or investors) is required to take immediate steps to come into compliance. However, given that PCA is the responsibility of the FRB, OCC and OTS with respect to State member banks, national banks and savings associations, respectively, it is not clear how the FDIC would enforce these “enhanced” PCA requirements.

Source of Strength

Although the FDIC’s initial proposal would have required that non-controlling private equity investors agree to serve as a limited source of strength for subsidiary banks or thrifts by agreeing to raise additional capital through the issuance of equity or qualifying debt, the FDIC dropped this requirement in the final Statement.

Cross Guarantee Liability

Overlapping groups of private investors that hold 80% or more of two or more covered institutions must pledge their stock in each such institution to pay for any losses suffered by the Deposit Insurance Fund as a result of the failure of, or providing assistance to, any other such institution. Under the initial proposal, this threshold would have been set at 50%. The FDIC has not explained whether the 80% threshold applies to voting shares, total equity or, conceivably, combined debt and equity, nor why an investor who is a member of such a group, but that cannot control a bank or thrift, should be required to provide a cross guarantee.

Transactions with Affiliates

Insured depositary institutions are already subject to quantitative and qualitative restrictions on extensions of credit to, or for the benefit of, their non-banking, non-subsidiary affiliates. However, the Statement expands these prohibitions to covered transactions with any private equity investor in a covered institution, its affiliated investment funds and any portfolio investment in which the investor or fund has an at least 10% equity interest. In contrast, the FRB, the OCC and the OTS already enforce limitations on affiliate transactions at the 25% ownership level under Regulation W.

Continuity of Ownership (Anti-Flipping)

Private investors in a covered depositary institution may not transfer any of “their securities” for three years without prior FDIC approval, which shall not be unreasonably withheld for transfers to affiliates, if the affiliate agrees to be subject to the conditions applicable to the transferring investor. It is not clear why the FDIC needs to impose this additional restriction, since the FRB, OCC and OTS already have discretion to impose a holding period in connection with approving a new bank holding company, a bank change of control or new savings and loan holding company.  

Offshore Secrecy Law Jurisdictions

A private investor may not invest directly or indirectly in a depository organization resulting from a bank or thrift failure through an entity domiciled in a “bank secrecy jurisdiction” unless the investor is directly or indirectly subject to comprehensive consolidated supervision (CCS) as recognized by the Federal Reserve, and the FDIC will have access to required information. Since private equity investors and their investment vehicles typically are not depository institutions, they are unlikely to be subject to CCS. Thus, this prohibition is likely to prohibit the use of any investment vehicle in a bank secrecy jurisdiction. The Statement’s description of such jurisdictions is vague and results oriented, leaving the FDIC with significant discretion in determining what constitutes a bank secrecy jurisdiction. Further, as with other provisions of the Statement that are redundant with existing regulation, the FRB, OCC and OTS already have discretion to impose these restrictions in connection with approving a new bank holding company, a bank change of control or new savings and loan holding company.

Disclosure

While the FRB, OCC and OTS already receive extensive information under existing regulations, the Statement puts private investors on notice, even in non-control positions, that they may be required to provide significant amounts of information to the FDIC, including with respect to entities in the ownership chain, the size of the capital fund or funds, diversification, return profile, marketing documents, management team and business model. Of course, the FRB, OCC and OTS already receive extensive information under existing regulations.

Conclusions

While the FDIC’s Statement is less onerous than its original proposal, the FDIC has not explained why so-called “private investors” who do not control a depositary institution should be treated differently from other non-controlling investors. Nor did the FDIC explain why any differences between so-called private investors and other investors justify more onerous restrictions to protect the Deposit Insurance Fund or the banking system generally, or why the existing supervisory structure for bank and thrift holding companies and the chartering of new institutions is inadequate to address the issues raised by the Statement.

The FDIC’s Statement has had a short-term impact already, and may have long-term effects as the markets digest the message and the FDIC interprets the Statement on a case-by-case basis. The FDIC has stated that it will review the operation and impact of the statement within six months of its approval date (by the end of March 2010), and make adjustments as it deems necessary. In the meantime, the Statement and evolving FDIC policy seem to be pointing in the following directions:

  • Private equity investors will likely be at a competitive disadvantage in bidding against strategic buyers whose investments are not subject to the Statement.
  • In situations where there are no strategic buyers for a failed institution, the FDIC will likely be required to provide more assistance to institutions acquired by private equity investors because of the higher capital requirements imposed by the Statement.
  • The FDIC is pursuing a strategy of transferring the deposits of a failed bank to a strategic bank acquirer, while selling the “bad assets” to special purpose entities in which partnership interests can be sold to private equity investors.
  • A variety of new investment structures will be used where PE investors are noncontrolling investors with well respected bankers or investors in established banking organizations which bid for failed banks.
  • There will be an increased number of recapitalizations of troubled regional and community banks by private investors that are interested in the financial services space, and see opportunities in bank stocks that are undervalued or where management is top notch.