The FDIC and Troubled Banks: Is the Door Still Open for Private Equity?

The most commonly articulated solution to the weakness in the U.S. banking sector since the current financial crisis began has been a call for more capital. This call has come from the U.S. bank regulators themselves, and, most significantly, has been implemented in actions by Congress and the Treasury Department in the TARP and the Treasury’s capital purchase program. One non-governmental source of capital, however, that has shown considerable interest in participating in bank rescues is private equity: numerous private equity firms have recently been raising capital with the goal of investing in troubled banks. In early July, the Federal Deposit Insurance Corporation (FDIC), the agency charged with resolving troubled banks and savings associations, issued a Proposed Policy Statement relating to such private capital investors, its “Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions.” As proposed, the FDIC’s Proposed Policy Statement appears to be a substantial deterrent to private equity investors, as, indeed, those investors have already publicly noted.

The Proposed Policy Statement would impose a series of obligations on private equity investors that do not exist under current law, the most significant of which are summarized below.

First, the Proposed Policy Statement states that certain investment structures, “typified by the so-called `silo’ organizational arrangements,” are “not to be considered as appropriate for approval for ownership of insured depository institutions” because “the beneficial ownership cannot be ascertained, the responsible parties for making decisions are not clearly identified, and/or ownership and control are separated.”

Second, depository institutions in which private equity investors had invested to facilitate failed bank deals would be subject to a super-capital requirement: such institutions would be required to be maintain a minimum Tier 1 leverage ratio of at least 15 percent for at least three years, and the investors would be expected to support the bank in maintaining that ratio, or face being subject to the prompt corrective action requirements of the Federal Deposit Insurance Act (the FDIA).

Third, the Proposed Policy Statement would impose a “source of strength” obligation on private equity investors’ “organizational structures,” a term that is not defined and therefore could extend to all entities in the private equity ownership chain.

Fourth, the Policy Statement would impose a requirement that “[i]nvestors whose investments, individually or collectively (my emphasis), constitute a majority of the direct or indirect investments in more than one depository institution,” would be expected to pledge to the FDIC “their proportionate interests” in each depository institution to pay for any losses to the FDIC insurance fund resulting from the failure of, or assistance provided to, any such other institution.

Fifth, the Proposed Policy Statement would prohibit extensions of credit by a depository institution “acquired or controlled” by private equity investors to the investors, their investment funds, any affiliates of either, and any portfolio companies, with “affiliates” being defined as a company in which a private equity investor owns 10 percent of more of the equity of that company.

Each of these five requirements is an extension of existing law. As to “silo structures,” this concept refers to setting up a private equity fund, separate from and not under common control with the fund manager’s other private equity funds, to invest only in banks and other depository institutions. The impetus behind such structures is to comply with the policy of the separation of banking and commerce contained in the Bank Holding Company Act of 1956 (the BHC Act). If a silo fund is not under common control with a private equity fund manager’s other funds that are not subject to a limitation on their activities and therefore may invest in commercial firms, then there is no mixing of banking and commerce. The Board of Governors of the Federal Reserve System (the Federal Reserve), the bank regulator charged with interpreting the BHC Act, has approved silo structures in the past as consistent with the BHC Act, subject to certain conditions.

Second, the 15 percent Tier 1 leverage ratio requirement is three times the ratio that a bank must maintain in order to be considered well-capitalized under existing law (five percent), and almost two times the ratio that a newly-chartered bank must maintain during its first three years of operation (eight percent).

Third, under existing law, the Federal Reserve, in interpreting the BHC Act, already imposes a source of strength obligation on holding companies that “control” a bank or other depository institution under the BHC Act, with “control” being conclusively presumed at 25 percent voting share ownership.

Fourth, under the FDIA, there is cross-guarantee liability for commonly-controlled depository institutions (with control being understood generally as co-extensive with the BHC Act definition of control).

Fifth, under the Federal Reserve Act and the Federal Reserve’s Regulation W, there are substantial limitations on bank/affiliate transactions (including extensions of credit), with “control” also generally understood as following the BHC Act definition of “control.”

What are the reasons for treating private equity investors differently from other private institutions that might seek to invest in a failing financial institution? In announcing the Proposed Policy Statement, the FDIC stated that “[t]he FDIC is particularly concerned that owners of banks and thrifts…have the experience, competence and willingness to run the bank in a prudent manner, and accept the responsibility to support their banks when they face difficulties and protect them from insider transactions.” The FDIC also stated that “[t]he measures contained in the Proposed Policy Statement will not be applied to individuals, partnerships, limited liability companies, or corporations, that accept the responsibilities under existing law to serve as responsible custodians of the public interest that is inherent in insured depository institutions.”

From these statements, and from the extra requirements that would apply to private capital investors, it seems clear that the FDIC believes that private equity investments raise greater safety and soundness concerns than investments in banks by individuals and bank or thrift holding companies. The extra requirements, moreover, would likely apply to (and would thus substantially deter) one currently contemplated structure for private equity investments, the so-called “club deal.” In this structure, a number of unaffiliated private equity firms make a non-controlling investment in a bank under the BHC Act under prevailing Federal Reserve interpretations of “control” – for example, five separate private equity investors each determine to invest in 20 percent of the voting shares of a new bank chartered to purchase assets and liabilities from a failing bank, and each investor has the right to appoint a director to the new bank’s board. If properly structured, such an investment could be viewed as non-controlling by the Federal Reserve, such that the private equity funds would not have a “source of strength” obligation to the new bank, and there would be no possibility of FDIA cross-guarantee liability.

Given the heightened requirements in the Proposed Policy Statement, it is not surprising that private equity firms have suggested modifications to the proposal, and noted that the heightened requirements would significantly deter private equity investing. What is not clear, moreover, is how the capitalization of a new bank by private equity investors to participate in a resolution of a failing bank differs from a common situation of a newly-chartered bank with FDIC insurance – in the latter case, the equity investors may all be individuals, so-called “friends and family” investors, who, as individuals, have no obligation to be called on to contribute capital to the bank beyond their initial contributions. In the latter case, the FDIC generally requires, for example, only an eight percent Tier 1 leverage requirement, even though there is no source of strength obligation from the individuals and no suggestion of cross-guarantee liability under the FDIA.

The FDIC, in my view, appropriately, published the Policy Statement as a proposal, subject to a comment period so that interested parties could give their views. Once these comments are received, the FDIC should give careful consideration to just how private equity funds differ from alternative investors in failed banks, and indeed from the typical equity investors in a newly chartered bank seeking FDIC insurance. (One manner in which private equity investors are different – that they generally seek to sell their investments within a shorter period of time than an acquiring bank holding company – seems to be addressed in another requirement in the Proposed Policy Statement, that the private equity investors retain their investment for at least three years.) The FDIC should also consider the effects of a freeze-out of private equity on its statutory responsibility to resolve failing institutions in the manner least costly to the government, and whether the safety-and-soundness concerns apparent in the Proposed Policy Statement could instead be satisfied on a case-by-case basis when particular private equity investments in troubled banks are considered. Finally, the FDIC should give additional consideration to the potentially beneficial aspects of capital contributions by private equity firms, which have amassed substantial private capital from their investor clients, in a financial environment in which the alternative players – existing banks, thrifts and their holding companies, on the one hand, and the U.S. Treasury on the other – are undoubtedly capital constrained.

Arthur Long is a partner at Davis Polk & Wardwell LLP, and practices in the firm’s Financial Institutions Group. He advises domestic and foreign banking organizations on the regulatory implications of mergers and acquisitions transactions; private equity and fund investments; the offering of new financial products, including derivatives; compliance and enforcement issues; bank insolvency issues; and, in the case of foreign banks, establishing U.S. branch and other offices.