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FDIC Issues Final Policy Statement on Private Equity Investments in Failed BanksJanuary 1, 0001
The Federal Deposit Insurance Corporation (the “FDIC”) recently issued a Final Statement of Policy on Qualification for Failed Bank Acquisitions (the “Final Statement”). The Final Statement purports to balance the need for additional capital in the banking system and the contribution that “private investors” (including, without limitation, private equity funds) could make to meeting this need, on the one hand, and ensuring that such contributions are consistent with the basic concepts applicable to the effective and prudent operation of insured depository institutions and the protection of the Deposit Insurance Fund (the “DIF”), on the other hand. The FDIC will review the operation and impact of the Final Statement within 6 months of its approval and thereafter will make any adjustments it deems necessary. Because it reflects a policy and not a regulation, the Final Statement is not a rule and is not binding on the FDIC.
The Final Statement reflects adjustments made to the July 2, 2009 Proposed Statement of Policy on Qualification for Failed Bank Acquisitions (the “Proposed Statement”) as a result of the FDIC’s review and consideration of comments received from a wide array of private investment firms, investment advisory firms, law firms, insured depository institutions, advocacy organizations, financial services trade associations, U.S. senators, labor unions, research organizations, academics and individuals. The Final Statement retains many elements of the Proposed Statement but makes significant changes to other elements; most notable among the changes is the removal of the “source of strength” requirement which would have required private investors to inject additional capital into an acquired depository institution in the event of certain financial difficulties. Although several commenters requested that the term “private capital investor” and similar terms used in the Proposed Statement be more precisely defined in light of the lack of a generally understood meaning for such terms, the FDIC, in an effort to retain maximum flexibility (albeit at the expense of clarity) revised the Final Statement to use the even more vague term “private investor.” While it is clear from the FDIC’s statements that private equity funds are intended to be covered under the “private investor” rubric, the uncertainty surrounding which other individuals and organizations are intended to be covered may discourage other potentially valuable investors from injecting additional capital into the banking system.
Scope of Applicability
The Final Statement applies prospectively to (a) private investors in a company proposing to assume deposit liabilities or assets from the resolution of a failed insured depository institution and (b) applicants for federal deposit insurance in the case of de novo charters issued in connection with the resolution of a failed insured depository institution.
Private investors who hold 5% or less of the total voting power of an acquired depository institution or its bank or thrift holding company would not be subject to the Final Statement in the absence of concerted action by such de minimis private investors (in which case they would likely constitute a “group” for the purposes of the Change in Depository Institution Control Act). The Final Statement does not apply to acquisitions of failed depository institutions completed before its effective date. In addition, a depository institution may apply to the FDIC for exemption from the requirements and prohibitions of the Final Statement if such institution has maintained a composite CAMELS rating of 1 or 2 continuously for a period of 7 years.
The Final Statement would also not apply to ventures between private investors and existing depository institution holding companies if the depository institution holding company has a strong majority interest in the resulting depository institution and an established record for the successful operation of insured depository institutions. The Final Statement affirmatively encourages such arrangements.
The Final Statement specifically acknowledges that the FDIC Board of Directors may waive one or more provisions of the Final Statement to the extent consistent with the best interests of the DIF.
The Final Statement requires that a depository institution acquired subject to the Final Statement must maintain a ratio of Tier 1 common equity to total assets of at least 10% for a period of 3 years from the time of the investment by private investors. For this purpose, Tier 1 common equity is defined as Tier 1 capital minus non-common equity elements (i.e., qualifying perpetual preferred stock, plus minority interests and restricted core capital elements not already included). Following the initial 3 year period, the depository institution must, for the duration of the period of ownership by private investors, maintain a level of capital adequacy that is no lower than “well capitalized” as defined in existing regulations. Ordinarily, the minimum Tier 1 leverage ratio for a depository institution is 4% and well capitalized depository institutions have a Tier 1 ratio of 5%.
The failure of the depository institution to maintain these standards will result in the institution being deemed “undercapitalized” for the purposes of Prompt Corrective Action rules and being subject to all applicable curative measures available to the depository institution’s regulator (including, but not limited to, divestitures, recapitalizations, additional restrictions on transactions with affiliates, changes to senior management and new elections for directors).
Continuity of Ownership
The Final Statement prohibits private investors, without prior approval from the FDIC, from selling or otherwise transferring their securities in a covered depository institution for 3 years following their acquisition. The prior approval of the FDIC will not be unreasonably withheld for transfers to affiliates of the private investor provided that the affiliates agree to be subject to the conditions applicable to the transferring private investor. The continuity of ownership requirements do not apply to any open-ended investment company which is registered under the Investment Company Act of 1940 and issues redeemable securities that allow investors to redeem on demand.
The Final Statement requires that if one or more private investors own 80% or more of two or more depository institutions, the stock of the depository institutions commonly owned by such private investor or investors must be pledged to the FDIC (e.g. in the context of private equity “club” deals, if Private Equity Firm 1 and Private Equity Firm 2 together own 80% of Bank A and they subsequently agree to acquire a combined 80% of Bank B, then their combined 80% interest in Bank A would be required to be pledged to the FDIC to secure against the potential failure of Bank B and vice versa). If any one of the commonly owned depository institutions fails, then the FDIC may exercise such pledges to the extent necessary to recoup any losses incurred by the FDIC as a result of the failure. The FDIC may waive this pledge requirement to the extent it would not alleviate the cost of such depository institution failure to the DIF.
Transactions with Affiliates
Transactions between controlled depository institutions and affiliates are strictly regulated. The Final Statement would expand those restrictions to include private investors who own more than 5% of the voting equity and at least 10% of the equity of a subject depository institution even in circumstances in which such investment yields no control over the underlying company. Specifically, the Final Statement prohibits all extensions of credit (other than pre-existing extensions of credit) by an insured depository institution to its private investors, their investment funds and any of either of their affiliates. For these purposes “affiliate” is defined as “any company in which the [private investor] owns, directly or indirectly, at least 10% of the equity of such company and has maintained such ownership for at least 30 days.” Private equity funds must keep in mind that this prohibition would prevent an acquired insured depositary institution from making any new extensions of credit to or otherwise acquiring any obligations of such private equity fund, its related funds and any of their respective portfolio companies that fall within the definition of affiliate. Private investors must provide regular reports to the insured depository institution identifying all of their affiliates.
Special Owner Bid Limitation
The Final Statement prohibits private investors that hold 10% or more of the equity of a depository institution in receivership from eligibility as a bidder to become an investor in the deposit liabilities or assets of that depository institution.
The Final Statement creates an expectation that private investors must submit to the FDIC information concerning themselves and all entities in their ownership chain including information concerning the size of the capital fund or funds, diversification, return profile, marketing documents, management team and business model. In addition, there is a requirement that private investors and all entities in the ownership chain provide the FDIC with such other information as is determined to be necessary to assure compliance with the Final Statement. The FDIC undertakes that any confidential business information submitted by private investors in compliance with their disclosure requirements shall be treated as confidential and shall not be disclosed except in accordance with applicable law. Before making investments that would subject them to the disclosure requirements of the Final Statement, private equity funds must consider the potential chilling effect these disclosure requirements may have with respect to their marketing efforts to potential limited partners as well as whether such disclosure is permitted by their fund documentation.
Secrecy Law Jurisdictions and Prohibited Structures
The Final Statement prohibits private investors organized in certain foreign jurisdictions from owning 5% or more of the voting equity of any subject depository institution.
In addition, the Final Statement prohibits private investors from using ownership structures that utilize entities that are domiciled in secrecy law jurisdictions except where such private investors are subsidiaries of companies that are subject to comprehensive consolidated supervision by the Federal Reserve Board and (a) have executed agreements requiring the provision of information to the primary federal regulator regarding the non-domestic entity’s operations and activities, (b) maintain their business books and records (or a duplicate thereof) in the U.S., (c) consent to the disclosure of information that might be covered by confidentiality or privacy laws and agree to cooperate with the FDIC, if necessary, in obtaining information maintained by foreign government entities, (d) consent to jurisdiction and designation of an agent for service of process, and (e) consent to be bound by the statutes and regulations administered by the appropriate U.S. federal banking agencies. For these purposes a “secrecy law jurisdiction” is defined as “a country that applies a bank secrecy law that limits U.S. bank regulators from determining compliance with U.S. laws or prevents them from obtaining information on the competence, experience and financial condition of applicants and related parties, lacks the authorization for exchange of information with the U.S. regulatory authorities, does not provide for a minimum standard of transparency for financial activities, or permits off shore companies to operate shell companies without substantial activities in the host country.” Private equity funds should note that the final clause of the foregoing definition regarding “shell companies” is quite expansive and could hinder their ability to use offshore entities to bid for failed depository institutions. That is to say, the final clause may cause otherwise transparent jurisdictions to be deemed “secrecy law jurisdictions.” If that were to be the case, private equity ownership structures using entities formed in those jurisdictions would be prohibited from bidding for failed depository institutions.
Finally, the Final Statement also prohibits the use of “complex and functionally opaque ownership structures in which the beneficial ownership is difficult to ascertain with certainty, the responsible parties for making decisions are not clearly identified and ownership and control are separated[.]” The FDIC sees such structures as substantially inconsistent with the principles of the Final Statement and not appropriate for approval for ownership of insured depository institutions. The FDIC guidance as to which structures are “complex and functionally opaque” states that such structures are ”typified by organizational arrangements involving a single private equity fund that seeks to acquire ownership of a depository institution through creation of multiple investment vehicles, funded and apparently controlled by the parent fund.”
The Final Statement expressly states that it is not intended to replace any determinations required by a depository institution’s primary federal regulator or a federal bank or thrift holding company regulator under any applicable regulation or statute.
 The six components of the confidential CAMELS rating system are used by federal regulators of depositary institutions to address the adequacy of Capital, the quality of Assets, the capability of Management, the quality and level of Earnings, the adequacy of Liquidity, and the Sensitivity to market risk. A rating of 1 through 5 is given, with 1 having the least regulatory concern and 5 having the greatest regulatory concern.
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