FDIC Adopts Final Rules for Private Equity Investments in Failed Banks

September 8, 2009

At the August 26, 2009 meeting of the Federal Deposit Insurance Corporation Board of Directors, the Board adopted final policies for the acquisition of failed banks by private investors such as private equity funds. Compliance with these rules is generally required for private investors to obtain bidding eligibility for failed institutions and for applicants for deposit insurance where new banking charters are issued in connection with the resolution of a failed institution. This article outlines the FDIC’s policies with respect to transactions of this type.

The policies adopted by the FDIC apply to private investors and acquirers of the deposits and operations of failed depository institutions, and to applicants for deposit insurance where a new banking charter is issued in connection with the resolution of the failed depository institution. The policies are to be applied prospectively. It is the FDIC’s intent that these policies are in addition to, and not in replacement of, existing holding company regulatory requirements, which means private investors must be wary of becoming subject to regulation as bank holding companies.

Notably, the policies do not apply to private investors in joint ventures with existing bank or thrift holding companies provided that the holding company has a significant controlling interest in the venture. The policies also do not apply to investors with less than five percent total voting power in the acquired depository institution unless there is evidence of a scheme to avoid the policies by using small investment holdings.

The policies apply for a period of seven years following the acquisition of the failed bank provided that the post-acquisition bank maintains a composite CAMELS rating of 1 or 2 continuously during that seven year period. [1]

The acquired depository institution must maintain Tier 1 common equity equal to at least 10 percent of the institution’s total assets for a period of three years after the acquisition. After three years the institution must maintain minimum capital at the “well capitalized” level during the remaining ownership period of the private investors. [2] If an institution falls below the required level the FDIC will deem the institution undercapitalized and would then have the right to enforce Prompt Corrective Action requirements with respect to the institution, including placing various limits on the institution’s operations.

Investors with equity interests of at least 80 percent in two or more newly acquired failed depository institutions will be required to pledge their equity interests in those institutions to the FDIC. The FDIC will be able to exercise its rights under the pledge agreement in the event one of the institutions fails to make up losses to the deposit insurance fund. As a practical matter this requirement may only rarely be applicable as most investors will limit their equity interest in any institution to less than 25 percent to avoid becoming classified as a bank holding company.

An acquired failed depository institution may not extend credit to its private investor owners who are subject to these policies or to their affiliates. Under these policies, an affiliate of a private investor is an entity in which the private investor directly or indirectly owns at least a 10 percent equity interest.

Private investors would be prohibited from selling or transferring their interest in the acquisition vehicle for a period of three years following the acquisition without the approval of the FDIC. The FDIC indicates it will grant approval of transfers to affiliates of a private investor provided the affiliate agrees to be bound by these policies in connection with the transfer.

Certain types of investors are prohibited from making bids to acquire failed institutions, and certain structures are prohibited as well. Investors who directly or indirectly own 10 percent or more of a bank or thrift in receivership will not be eligible to bid for the deposits or assets of a failed institution. In addition, an investor employing one or more entities domiciled in a banking secrecy jurisdiction will not be eligible to own a direct or indirect interest in an insured depository institution unless the investor is subject to comprehensive consolidated supervision recognized by the Federal Reserve Board, and it agrees to provide information to the primary federal regulator.

In addition, complex and opaque acquisition structures are not favored by the FDIC. The FDIC policy statement provides an example of such a disfavored structure: a private equity fund seeks to acquire ownership through the creation of multiple investment vehicles funded and controlled by the parent fund. This suggests that one of the only permissible structures is a direct investment into, and ownership of, the acquisitions vehicle by one or more private equity funds. The policy issue which leads to this requirement is that private equity funds may use multiple layered entities to, in substance, own 25 percent or more of an institution but avoid the private equity fund itself becoming classified as a bank holding company.

The FDIC will also require significant disclosure from the investors throughout the chain of ownership.

The foregoing are policies as opposed to detailed statutory or administrative rule provisions thus they lack definition. Indeed a number of the terms used in the FDIC’s policy statement do not have generally agreed upon definitions. This provides the FDIC flexibility in their application while also creating some planning opportunities and uncertainty for private investors with respect to the structuring of an acquisition transaction. The policy statement provides the Board of Directors of the FDIC with the right to waive one or more of the policy provisions if the Board determines that waiver is in the best interest of the deposit insurance fund. One can likely expect that the waiver of various policy requirements will be more readily available to bidders for the most unattractive failed institutions.

[1] CAMELS is an international bank rating system. The name is an acronym for “capital adequacy, asset quality, management quality, earnings, liquidity, and sensitivity to market risk”. Banks with scores of two or lower are considered to be institutions which present few supervisory concerns. The ratings are typically developed in connection with an onsite examination of the relevant bank.
[2] “Well capitalized” refers to a Total Risk-Based Capital Ratio equal to or greater than 10 percent, a Tier 1 Risk-Based Capital Ratio equal to or greater than 6 percent, and a Tier 1 Leverage Capital Ratio equal to or greater than five percent. The equity used in these metrics may include non-common equity capital.