FDIC Proposes Rules for Acquisition of Failed Depository Institutions By Private Equity Investors

UPDATED: FDIC Adopts Final Rules for Private Equity Investments in Failed Banks (09/08/2009)
At its July 2, 2009 meeting, the FDIC’s Board of Directors issued proposed rules related to the acquisition of failed depository institutions by private equity investors. These proposed rules are designed to address investment structures involving “shell holding companies owned by another entity or entities that avoid certain of the responsibilities of bank and thrift ownership…” [1] This may be perceived as a response to recent transactions in this area by private equity funds using a consortium structure to avoid subjecting themselves to the Federal Reserve’s bank holding company rules by limiting their interest in the acquisition vehicle to less than 25 percent and otherwise limiting their control. [2]

These transactions involve the creation of a holding company which the private equity investors own, and a new depository institution entity which acquires the assets and deposit obligations of the old failed depository institution with the FDIC serving as the receiver for the failed institution. This is the structure the proposed rules appear to assume will be employed.

The proposed rules would apply to:

1. Private capital investors in an acquisition entity that would directly or indirectly acquire the deposits of a failed depository institution provided that the acquisition entity is not a bank or thrift holding company that existed or was acquired by the private capital investors more than three years before the effective date of the proposed rules.
2. Applicants for deposit insurance with respect to new charters issued in connection with the resolution of a failed depository institution.

Significant requirements incorporated in the proposed rules would require investors to:

1. Cause the underlying depository institution acquiring the deposits to maintain a minimum 15 percent Tier 1 leverage ratio for three years after the acquisition. Broadly, the Tier 1 capital ratio is defined as Tier 1 Capital divided by Average Total Consolidated Assets. The Tier 1 leverage ratio requirements for institutions deemed financially strong is 3 percent while all other institutions must maintain a 4 percent ratio. [3] In essence this means that that the amount of equity provided in connection with the acquisition of a failed bank’s assets would be significantly greater than required for other institutions as a percentage of assets.
2. Agree to serve as a “source of strength” for the subsidiary deposit institution meaning that the holding company or investment vehicle used by investors must itself commit to raise capital for the subsidiary depository institution under certain circumstances. This requirement is vaguely defined and may include commitments from investors themselves.
3. Pledge their proportionate interests in all other depositary institution holding companies, if they are significant multi depository institution investors, to the FDIC to make the FDIC whole in the event any of such an investor’s depository institution investments requires the payment by the FDIC of a claim.
4. Make significant disclosures to the FDIC about themselves and “all entities in the ownership chain” including the size of their capital funds, diversification, return profile, marketing documents, management team, and business model.
5. Hold and not transfer any security in the depository institution holding company or the depository institution for at least three years following the acquisition of the deposits unless the FDIC authorizes such a transfer.

In addition, an individual who holds at least a 10 percent interest in a failed depository institution would not be permitted to participate as an investor in the direct or indirect acquisition of the deposits of such a failed depository institution. Moreover, a new insured depository institution subsidiary which has acquired the deposits of a failed institution would be prohibited from extending credit to an investor in its holding company investor or an affiliate of an investor such as an investor’s portfolio company.

These proposed rules present general concepts and their impact on the amount of new equity available to recapitalize failed depository institutions will depend on the details of any final rules and on the generosity of the applicable regulators with respect to the business terms of these transactions among other matters.

[1] Federal Deposit Insurance Corporation, Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions, page 9, Proposed June 2, 2009.
[2] 12 U.S.C.1841(a); Peter Lattman and Mattias Rieker, Private Equity Goes Banking with Federal Assist, The Wall Street Journal, May 23, 2009, Page B3.
[3] 12 C.F.R. Part 225, Appendix D