BANK CONTROL RULES EVOLVING TO BALANCE NEED FOR NEW CAPITAL AND REGULATORY POLICIES

By Thomas P. Vartanian

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 twenty-four 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 non-control 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 non-controlling 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.

HEIGHTENED MANAGER CONCERNS FOR SECONDARY TRANSFERS

By Richard I. Ansbacher, Kenneth I. Rosh and Rebecca Neuschatz Zelenka

Liquidity concerns created by the recent financial crisis have resulted in fund managers receiving an unprecedented number of requests by investors to transfer interests in private equity funds. In particular, certain investors need to liquidate some of their holdings, even at low valuations, while others are looking for ways to avoid defaulting on their capital commitments. Although fund managers have, in the past, generally dealt with transfer requests as an accommodation to investors, current conditions may motivate fund managers to be more accommodating to these investors.

  • Secondary transfers may help avoid investor defaults, which reduce the size of the investment pool and may have an adverse impact under a fund's contractual arrangements, including credit facilities. In addition, imposing remedies on defaulting investors may lead to complications and uncertainties in the operation of the fund.
  • Because fund managers are generally interested in building a foundation of strong investors for future funds, admitting replacements for defaulting or financially weaker investors is an opportunity to build toward this goal.
  • Secondary purchasers investing at today's reduced valuations may be more inclined to work with fund managers who may be looking to modify the terms of an existing fund or form follow-on vehicles.
  • Accommodating a transfer by an investor with liquidity concerns may lay the groundwork for a future relationship once the transferring investor again has capital to invest.

While there are many benefits to facilitating secondary transfers, fund managers should take into account various considerations before approving any transfer request.

Ambiguities In Fund Documents

The transfer provisions in many fund documents do not address situations arising in the current environment. For example:

Manager Acquiring Discounted Interests

Because of liquidity needs or fear of default, investors may be willing to transfer fund interests for deeply discounted prices. For various reasons (including trying to efficiently resolve potential default situations), fund managers may want to acquire these interests for their own account. Fund documentation, however, is often not clear on whether the manager can acquire discounted interests without offering the purchase opportunity to other fund investors. This situation is complicated by the fact that if the investor were to default, in many circumstances, the other investors would be credited with a portion of the defaulted interest. Therefore, there is a potential conflict if the manager acquires the interest at a steep discount prior to a likely investor default. Certainly, if the fund documents give current fund investors a right of first refusal or pre-emptive rights, those provisions would apply. But even in the absence of those provisions, the manager may be in a difficult situation in deciding whether to acquire the interest and at what price.

Waiving Default Interest

In many circumstances, fund interests are sold after the investor has failed to meet a capital call. Almost all fund documents allow (and some require) the manager to impose late-payment interest charges on a delinquent investor. However, many fund documents do not address whether the fund manager has the discretion to waive interest that has accrued after a default in order to facilitate the sale of the interest. Although the fund manager in such a situation could reasonably take the position that it is in the best interests of all investors to facilitate a sale in lieu of a default, it is more difficult to take this position when the fund documents require that interest be charged.

Heightened Risks For Fund Or Manager

Fund managers may face additional credit and other risks from transfers of interests.

Liability For Clawback Obligations

In general, fund-transfer agreements require the transferee to step into the shoes of the transferor with regard to all liabilities associated with the acquired interest. Accordingly, the transferee is typically responsible for meeting all capital call obligations, including those associated with an investor clawback (i.e., a recoupment of prior distributions to cover fund liabilities). In some cases, however, the transferor and the transferee may agree outside of the fund documentation, and without informing the manager, that the transferor will remain liable for these obligations. For example, the purchase and sale agreement between the transferor and transferee, to which the fund and the manager are not parties, may require the transferor to satisfy any investor clawback obligations relating to fund realizations prior to the transfer. In the event that an investor clawback arises in the future, the transferee may take steps to avoid the obligation, attempting to pass responsibility to the potentially financially constrained transferor. While the fund manager would ultimately have the legal right to recover from the transferee, there may be delays, enforcement costs, and potentially, damage to the manager's relationship with the investor.

Limited Liability Blocker Entities

A transferee may attempt to acquire a secondary interest through an entity that insulates the ultimate purchaser from liabilities associated with clawbacks or other unanticipated capital calls. In prior economic times, many fund managers paid little attention to investors who structured their investments through limited liability, judgment proof entities, especially when these entities were put in place for tax planning purposes. In the current economic environment, however, fund managers must pay attention to the entity that is admitted to the fund as part of a transfer, and should consider requiring parent guarantees for the financial obligations associated with becoming an investor.

Additional Manager Representations

Secondary investors generally conduct due diligence on funds and fund managers as part of their acquisition of a fund interest. Fund managers must balance their desire to facilitate a transfer with the need to protect themselves from potential liability. For example, if a potential transferee is reviewing the fund's financial statements, the fund manager should make clear in any transfer documents that the financial statements were not intended to be used for (and should not be relied upon for) determining the purchase price of an interest. Managers should be particularly careful not to make representations regarding potential investor clawbacks or recycling provisions. In addition, sharing detailed information with a potential secondary investor that is not shared with all fund investors can create an information asymmetry between the selling investor and the secondary investor, as well as between the secondary investor and the other investors.

Equivalent Treatment Of Investors

Fund managers may be faced with the need to deal with defaulting investors several times over the life of a fund. When considering what action to take in a particular situation, a manager should take care to treat all defaulting investors fairly, to take actions that best fit the particular circumstances, to consider the precedent created by its actions, and to consider the best interests of the fund and investors in evaluating default remedies. While different default situations may warrant different responses, investors may question why the manager handled one situation differently from another, and a manager will want to avoid the appearance of arbitrarily imposing a harsher penalty on one defaulting investor than another. Some default remedies, such as the manager itself acquiring the fund interest from the defaulting investor, may benefit the manager or the principals, and give rise to the appearance of impropriety. The manager must take care to minimize, and appropriately address, any actual or perceived conflicts of interest.

Lessons Learned For Future Funds

While the current pressures on fund managers will soon pass, a similar economic cycle is likely to arise at some point in the future, and managers can take steps now to ensure that the transfer provisions in new fund documents reflect the lessons learned from the current economic situation. Some items to consider for future funds include:

  • Allowing the manager greater flexibility to facilitate transfers, including by providing the manager (or an affiliate) with the explicit ability to acquire interests from investors, or to force a sale to a third party, without regard to minimum price or offering the interest to other investors. These provisions should provide the manager with significant discretion in determining a fair price, and explicitly state that an auction or third party valuation is not required.
  • Allowing the manager the explicit right to waive or reduce interest charges for delinquent investors. While fund documents entered into in connection with future fundraising may become more onerous on defaulting investors, fund managers will need as much flexibility as possible to avoid an actual default and to help attract potential transferees. In particular, the transfer provisions should be coordinated with any forced sale provisions in the case of a default.
  • Including extensive disclosures in the offering memorandum about the potential detriments to non-transferring investors from the sale of distressed interests, such as having to bear interest expenses at the fund level to cover delinquent payments, or having to make additional contributions to cover the defaulted amount.
  • Considering transfer logistics when establishing a fund structure. For example, a structure that restricts all tax-exempt investors to selling only to other tax-exempt investors may make it more difficult to market fund interests. If possible, build in the flexibility to transfer commitments between fund vehicles in connection with a transfer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.