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— Judgment Call —
Corsair Capital LLC's investment in National City Corp. and TPG Capital's investment in Washington Mutual Inc. are but the latest of a growing trend. Given the state of the banking industry, there will surely be many similar forays into the banking business. There is no shortage of candidates seeking equity, and the list grows longer daily. However, these transactions are fraught with complexity and careful guidance is essential. Certainly, the banks need the capital. One of the interesting results of our last banking crisis in the late 1980s and early 1990s is a regulatory framework that puts a premium on remaining "well capitalized" under all applicable standards.
Indeed, in order to conduct business without excessive regulatory interference, banks must maintain capital at this level. The turmoil in the real estate markets has led directly to increased write-offs and reserves, driving down capital ratios. The corresponding decline in stock prices and uncertainty of asset values have essentially cut off the public markets, and many natural acquirers are sidelined with their own problems. As a result, private equity funds and their kindred cousins, hedge funds and sovereign wealth funds, have become the capital source of choice (or if not choice, of necessity). The banks' need for capital and the private equity funds' resources might suggest this is a marriage made in heaven. If it is a marriage, however, the Bank Holding Company Act, and its sister, the Savings and Loan Holding Company Act, make it a marriage peculiarly hard to consummate. Any company that "controls" a bank or thrift is a bank or thrift holding company, and is subject to supervision and examination, reporting obligations and a series of activity restrictions that essentially preclude the ownership and operation of commercial businesses. "Control" can arise with equity ownership interests as low as 10%. The addition of commercial rights such as board seats, veto power over significant transactions or other similar powers are all indicia of control. These restrictions mean that the fund will need to structure its investment carefully. It will either need to make a minority, passive investment, avoiding all of the holding company restrictions, or must make sure that the holding company restrictions do not adversely affect the fund and its investors. In general, we have seen funds create new entities, separate enough from the fund, its managers and its major investors, where only the new entity can be regulated as a holding company. A great deal of what is going on in structuring these investments can be characterized as angels dancing on the head of a pin. If I own 10% of the bank, is one board seat too much? Could I be found in control at 9.9%? Can I preclude a change of business without consent? If one investor owns 20% of my special purpose fund, is that investor subject to the holding company restrictions? To make things worse, the guidelines emanating from the regulators are vague, uncertain and certainly not well publicized. It is time for a rational, thoughtful approach to the holding company issue. Banks need capital; private equity firms have capital. A fund that lacks the actual power to control the management of the bank's policies should not be a bank holding company; a fund that has the power should be. However, the regulation that accompanies that status should recognize its unique features. Just as the Federal Reserve spends little time worrying about the investments of the merchant banking arms of Citigroup Inc., J.P. Morgan Chase & Co. and Bank of America Corp., it should spend little time worrying about the commercial investments of Blackstone Group LP, Citadel Investment Group LLC or Carlyle Group if they decide to make a controlling investment in a bank. We went through a crisis in the savings and loan industry in the
1980s. We invited, and received, substantial commercial investments in
that industry. The world did not end. Indeed, there were no problems
resulting from those investments. It was a practical, pragmatic and
perfectly appropriate means of recapitalizing troubled institutions. We
should be equally practical, pragmatic and appropriate today. John Douglas, a former general counsel of the Federal Deposit Insurance Corp., is the chairman of the global bank regulatory practice of Paul, Hastings, Janofsky & Walker LLP. |
One of the unusual aspects of the current banking crisis is the degree to which the private equity firms are recapitalizing financially troubled institutions. 
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