Relatively high valuations in banking, coupled with leverage limitations and other regulatory restrictions have historically discouraged private equity investments. But the credit crunch and subsequent recession have marked a new era. The resulting decline in bank stock prices has sparked new interest in financials for private equity investors; the challenge is to make such investments while avoiding regulatory land mines.

There are several regulatory issues that must be addressed if a company is in "control" of a financial institution, while some circumstances have allowed ownership and influence without a finding of control for regulatory purposes. Keep the following in mind.

Know the ramifications of control. An entity controlling a financial institution is deemed to be a bank or thrift holding company. Such holding companies are subject to significant rules and restrictions, including:

Limitations on leverage. Bank holding companies with total assets of $500 million or more are required to meet consolidated capital guidelines. These guidelines include a leverage ratio (core capital divided by average assets) of generally at least 5% and a total risk-based capital ratio (all sources of capital, including certain hybrid capital elements divided by risk-weighted assets) of 10%. If the bank holding company has less than $500 million in total assets, then below this threshold, there is a debt-to-equity-ratio limitation. Thrift holding companies do not have quantitative capital requirements, but they do have qualitative limitations on the amount of leverage.

Activity restrictions. Generally, financial institution holding companies are restricted to activities that are financial in nature, so nonqualifying investments must be divested.

Affiliate restrictions. Transactions with affiliated parties (entities under common control or those that control the financial institution) must be on arm's-length terms. Certain types of transactions are subject to high collateral requirements and are otherwise limited.

Source-of-strength doctrine. The Federal Reserve requires a bank holding company to serve as a "source of strength" to a bank it controls.

Oversight. Bank holding companies are subject to examination and supervision by the Federal Reserve. Thrift holding companies may be examined by the Office of Thrift Supervision, or OTS, in certain circumstances.

Nonbanking acquisitions. Prior approval may be required to acquire control of a nonbanking entity.

Cross-guarantees liability. Financial institutions that are controlled by the same holding company are potentially liable for the obligations incurred by their sister financial institutions.

The key to determining whether these restrictions are applicable is whether the PE fund, or any entity for that matter, controls the financial institution for regulatory purposes.

So what is control? The bank regulatory authorities deem control to exist at much lower ownership percentages than actual control or even practical control. A company controls an entity if: the company, directly or indirectly or acting through one or more persons, owns, controls or has the power to vote 25% or more of any class of the entity's voting stock; the company has the ability to appoint a majority of the entity's directors; or the company has the ability to exercise a controlling influence over the management or policies of the entity.

The term "company" is expansively defined to include any type of entity. The regulators will also evaluate the quality of the security. A security, such as a preferred stock, still may be determined to be voting. The regulatory authorities also have factors that they evaluate to determine whether a company exercises a "controlling influence" over another entity.

The regulatory authorities presume control to exist at lower ownership thresholds than even the 25% bright-line test. Traditionally, control of a bank holding company was presumed to exist at 10% of the outstanding shares unless the nonbanking entity made certain passivity commitments. In September, the Federal Reserve relaxed the thresholds and softened the presumption of control. The changes included:

• A minority shareholder may own up to 33% of the total equity of a banking organization, provided that it does not own, control or have power to vote more than 15% of any class of voting securities. Again, the 25% of any class of voting securities threshold is still a bright-line test for control.
  
• A minority shareholder that is above the 10% threshold may have at least one board seat.
  
• A minority shareholder can now seek to influence policy, as can any other shareholder.
  
• A minority shareholder may now engage in business relationships with a bank or bank holding company on a case-by-case basis. The Federal Reserve will pay particular attention to the size of the relationships and whether transactions are on nonexclusive market terms and may be terminated without penalty.
  
• Finally, a minority shareholder may require, as part of a shareholders' agreement, covenants, such as those prohibiting the issuance of senior securities or senior borrowings, consultation rights and rights to financial information. More extensive covenants, such as limitations on hiring, firing, increasing compensation, raising additional debt or capital or engaging in new lines of business, may be deemed to represent a controlling influence.

These tests were applied when the Federal Reserve approved the applications of GMAC LLC and IB Finance Holding Company LLC (collectively GMAC) to become bank holding companies and GMAC bank to convert from a Utah industrial loan company to a commercial bank. Cerberus Capital Management LP agreed to distribute shares to its respective investors to reduce its ownership of GMAC from a majority of the shares to less than 14.9% of the voting shares and 33% of total equity. General Motors Corp. agreed to reduce its ownership to less than 10% of the voting and total equity of GMAC. The remainder of GM's ownership in GMAC was transferred to a blind trust to be disposed of within three years. GM agreed to comply with restrictions on transactions with affiliates.

For federal savings banks, the tests are similar but not the same. The OTS also will evaluate the circumstances to determine whether to rebut a presumption of control for a 10% or more owner of voting shares. The OTS has shown flexibility in allowing investments for thrifts and thrift holding companies of less than 25% of the equity and less than 35% of total equity and debt of a thrift.

For PE firms, the challenge is to be able to influence the bank's direction without becoming subject to banking restrictions.

Peter G. Weinstock is practice group leader of the financial institutions corporate and regulatory section of Hunton & Williams LLP.