Stringent rules for PE in failed banks

The Federal Deposit Insurance Corp. board on July 2 authorized publication for public comment of a proposed statement of policy on qualifications for failed bank acquisitions. The policy statement would establish new standards for bidder eligibility for private equity investors and similar nonbank investors seeking to acquire or invest in failed depository institutions through the FDIC receivership process ("failed banks"). The FDIC has entered into some high-profile transactions of that type with PE investors recently as part of its efforts at resolving the ever-increasing number of failed banks.

The policy statement is remarkable not only in its lack of specificity in its material provisions but also in its surprisingly far-reaching policy prescriptions. The latter would impose new regulatory requirements and restrictions -- including extraordinary capitalization requirements for covered depository institutions, source of strength obligations and cross-guarantee liability for noncontrolling investor organizations, and minimum holding periods for depository institution investments -- that are in some cases substantially more burdensome than those applicable to depository institutions owned by traditional holding companies and that go well beyond the requirements imposed by applicable law. If adopted in final form and applied broadly, these policy prescriptions could put PE investors at a substantial competitive disadvantage vis-à-vis other potential investors in failed banks and would likely cause many PE investors to reconsider their strategy of investing in them.

The policy statement is applicable to (i) "private capital investors" in a company (other than a bank holding company or thrift holding company that has come into existence or has been acquired by such investors at least three years prior to the final policy statement) that is proposing to directly or indirectly acquire a failed bank; and (ii) applicants for FDIC deposit insurance for a de novo depository institution being chartered in connection with an acquisition of a failed bank.

The policy statement appears to be targeted primarily at PE investors and consortia of PE investors (commonly referred to as "club deals") seeking to participate in the FDIC bidding process for failed banks through newly formed holding companies, or newly chartered or recently acquired depository institutions, where the PE investors have not taken controlling equity stakes so as to avoid regulation as depository institution holding companies under federal banking law. A PE investor with a "de minimis investment" (not defined in the policy statement) would not be covered.

In the provision likely of greatest concern to PE firms, the policy statement would require investors to commit to the FDIC to cause the depository institution acquiring the banking operations of a failed bank to be initially capitalized for three years at a minimum 15% Tier 1 leverage ratio (representing a multiple of normal requirements), subject to possible FDIC extension. After the initial period, investors would be required to maintain the depository institution in "well capitalized" status throughout the remainder of their ownership, including being required to "immediately facilitate restoring" the institution to that status if it falls below it and with certain regulatory restrictions on the institution being triggered by a failure to do so. This provision would have the effect of creating a completely separate set of capital standards, perhaps unprecedented in their stringency, for depository institutions with PE ownership that acquire failed banks.

On a related issue, the policy statement provides that "investors organizational structures" would be expected to agree to serve as a source of strength for their subsidiary depository institutions, which the policy statement states would require the depository institution's holding company to commit to sell equity or engage in capital qualifying borrowing in order to be in a position to provide financial support to the institution in times of financial stress or adversity. If applied only at the holding company level, this source-of-strength obligation would essentially be a reiteration of existing regulation, but the FDIC's request for public comment suggests that the agency is also considering imposing a source-of-strength commitment directly on the PE investors holding noncontrolling equity stakes in the holding company. Imposing such an obligation on an indirect, noncontrolling stockholder would be highly unusual if not unprecedented as both a bank regulatory and general corporate law matter.

The policy statement also contains a cross-guarantee provision that provides: "Investors whose investments, individually or collectively, constitute a majority of the direct or indirect investments in more than one insured depository institution would be expected to pledge to the FDIC their proportionate interests in each such institution to pay for any losses to the deposit insurance fund resulting from the failure of, or assistance provided to, any other such institution."

This provision appears aimed at the members of overlapping PE consortia investing in depository institutions, and as drafted it would seem to apply to any such member regardless of the size of its ownership stake, although perhaps subject to a de minimis threshold. Under this approach, a PE investor participating in two or more depository institution club deals (at least one of which involved an acquisition of a failed bank) and holding more than a de minimis equity stake in each of the two depository institutions could in theory become subject to the cross-guarantee requirement if the combined direct or indirect ownership stake in each of the underlying depository institutions of at least some of the common members in the two consortia represented at least 50.1%.

Investors subject to the policy statement would also be prohibited from selling or otherwise transferring securities of the investors' holding company or depository institution for three years after the acquisition of the failed bank from the FDIC without advance FDIC approval, which the FDIC indicates it would not grant unless the purchaser were to agree to assume the selling investor's obligations under the policy statement. In addition to being a substantial restriction on investors' fundamental property rights, it is unclear how this three-year minimum ownership period would affect the ability of PE investors to take the depository institution or its holding company public during that time frame.

The policy statement would also: