Release of FDIC Policy Statement on Qualifications for Failed Bank Acquisitions by Private Capital Investors

July 7, 2009

Gibson, Dunn & Crutcher LLP is closely monitoring risks and opportunities arising from the recent and dramatic reshaping of our capital and credit markets.  We are providing updates on key transactions as well as regulatory and other legal developments that we believe could prove useful as financial institutions, investors, financial sponsors and other entities navigate these transformative times.

On July 2, 2009, the FDIC Board approved the issuance of a proposed policy statement on qualifications for failed bank acquisitions.  The proposed statement is intended to provide guidance to private capital investors interested in acquiring or investing in the assets and liabilities of failed banks or thrifts.  The FDIC set out nine specific questions for comment, including whether capital requirements should be raised as dramatically as proposed.  Comments will be accepted for 30 days and posted on the FDIC website.

The FDIC’s proposals were immediately met with a sharply negative response from representatives of the private equity community who complained that the proposals both (i) put private capital bidders for failed institutions at a competitive disadvantage (as compared to bidders that are already insured depositary institutions) due to higher capital ratio requirements (and thus lower potential returns on equity) and (ii) significantly increased the risk profile of the transaction for private capital buyers due to a mandatory minimum holding period for the investment in the acquired institution and a required cross guarantee.  The three proposed requirements on which their attacks were focused (discussed in greater detail below) were:

1. Depository institutions acquired by private capital investors would be required to be "very well capitalized" at a Tier 1 leverage ratio of 15% for at least three years, after which the institution could be maintained at a "well capitalized" level;
2. Private capital investors would be prohibited from selling the acquired depository institution for three years without FDIC approval; and
3. Private capital investors would be required to provide a cross guarantee pledging to the FDIC their ownership interests in the other financial institutions to pay for any losses to the Deposit Insurance Fund (DIF) if one of the institutions fails.

The private equity sector was not alone in these criticisms.  Senior federal financial regulatory officials were quick to complain that the proposal would go too far and would have the effect of cutting off access to private capital.

On July 6, 2009 the FDIC held a roundtable discussion with interested parties to discuss the proposed policy statement.  The private equity participants were critical of certain aspects of the proposal, including the three provisions listed above, but were supportive of other aspects of the plan, including the ban on private equity firms bidding on their own failed banks.[1]  While the July 6 meeting was a closed session, reports indicate that private equity participants came away mollified by their perception that the FDIC proposals remained discussion points open to public debate.

The reactions to these proposals, especially the 15% Tier 1 leverage ration requirement, were not unexpected by the FDIC.  FDIC Chairman Sheila Bair said in a statement accompanying the FDIC’s release that in making the 15% proposal "we are opening high." 

The main driving force behind the proposals appears to be mitigation of risk to the DIF posed by the possibility of these banks failing a second time.  Chairman Bair commented in her statement accompanying the release that "we don’t want to see these institutions coming back."  She also noted that the FDIC had specific concerns about private capital investor bids and had already imposed special restrictions on private capital bidders, including higher capital requirements.  She noted that bids from private capital investors had been observed to include certain troubling provisions — though she noted that the bids containing these troubling provisions had failed — including:

• Structures in which it is difficult to determine actual ownership
• Bidders seeking permission to immediately flip ownership interests[2]
• Structures organized in secrecy law jurisdictions

The FDIC release sets forth the following broad areas of concern that the proposed rules are intended to address:

• That the acquired depository institutions be adequately capitalized
• That new management has the expertise and competence required to succeed
• That new management is committed to providing banking services in a safe and sound manner for the long term
• That acquired banks be protected from insider transactions

To that end, the release proposes standards for bidder eligibility, including:

• Capital Commitment.  A minimum level of capital support for the acquired depository institution.  Specifically, maintaining a minimum 15% Tier 1 leverage ratio for a period of three years that, if not met, will render the institution "undercapitalized."
• Source of Strength.  A commitment from the holding company in which Investors have invested and that holds stock in the depository institution to serve as a source of capital for the depository institution subsidiary, either by selling equity or issuing qualifying debt.
• Cross Guarantee.  An agreement from Investors owning a majority of the investments in more than one insured depository institution to provide a cross guarantee pledging to the FDIC their interests in the other institutions to pay for any losses to the DIF if one of the institutions fails.[3]
• Transactions with Affiliates.  Prohibition on all extensions of credit to Investors and their affiliates by an acquired depository institution, with "affiliate" defined as any company in which an Investor owns 10% or more of equity.
• Secrecy Law Jurisdictions.  A prohibition on Investors employing ownership structures using entities domiciled in bank secrecy jurisdictions unless the Investors are subsidiaries of companies subject to comprehensive consolidated supervision by the Federal Reserve Board and they agree to a number of requirements including maintaining books and records in the U.S., and consent to disclosure requirements and to U.S. jurisdiction.
• Owner Bid Limitations.  Investors owning 10% or more of the equity in a depository institution would be ineligible to bid on the deposit liabilities or assets if the institution failed.
• Continuity of Ownership.  A prohibition on Investors selling their securities in the holding company or depository institution for three years following acquisition without FDIC approval.
• Disclosure:  Detailed disclosure requirements to the FDIC including size of the capital fund, its diversification, the return profile, management team and business model. 

While the FDIC invited comments on all aspects of the policy statement, it set out nine specific questions that it wants addressed during the 30-day public comment period, as follows:

1. Propose a definition for the "Investors" to be covered by the policy statement.  The FDIC is initially proposing to exclude all parties other than "private capital investors in certain companies" and "applicants for insurance in the case of de novo charters issued in connection with the resolution of failed insured depository institutions."
2. Whether "silo" structures where beneficial ownership cannot be ascertained, the parties responsible for making decisions are not identified, or where ownership and control are separated should be considered eligible bidders.
3. Whether the acquired depository institution should be required to maintain a 15% Tier 1 leverage ratio for at least three years and thereafter maintain a "well capitalized" level.  Also, whether failure to maintain the 15% level should trigger "undercapitalized" treatment.  There seems to be recognition at the FDIC that requiring maintaining such a high level could make the institution uncompetitive.  Indeed, the 15% level appears quite high when considering that under normal conditions the FDIC considers depository institutions with a Tier 1 leverage ratio of at least 5% to be "well capitalized" and of at least 4% to be "adequately capitalized."[4]
4. To what extent should the Investors, including the holding company owning the depository institution’s stock, be required to act as a source of strength for the depository institution, including whether the Investors should simply pledge to — or in the alternative have an affirmative obligation to — raise additional equity or engage in additional borrowing to support the depository institution?
5. Should investors owning the majority of more than one insured depository institution be required to pledge to the FDIC their interests in each institution to pay for any losses to the DIF resulting from the failure of the institution being acquired and should this cross-guarantee commitment be enhanced to require a direct obligation of the Investors?
6. Should entities established in bank secrecy jurisdictions be considered eligible bidders whether or not they are subject to comprehensive consolidated supervision by the Federal Reserve Board?
7. How long should Investors be prohibited from selling their securities in the holding company or depository institution following acquisition without FDIC approval — the FDIC is proposing three years?
8. Should Investors that hold 10% or more of the equity of a depository institution be considered ineligible to become investors in the deposit liabilities and assets if the institution fails and is this rule needed to assure fairness and to avoid an incentive to take advantage of loss sharing?
9. Should the limitations in the proposed policy statement be lifted if the depository institution is operated successfully for a number of years?

Comments must be submitted within 30 days of the statement’s publication in the Federal Register.  Since this date would fall on the first weekend in August, we suggest comments be submitted by Friday, July 31.

We expect the comments to continue to be highly critical of certain aspects of the FDIC’s proposal.  While private equity investors have recently acquired only a small number of the many banks passing through FDIC receivership, those transactions — including for Indymac and BankUnited — have been among the larger and more capital hungry deals.[5]  Syndicates of private equity firms structuring investments in a manner that avoids triggering bank holding company requirements promise to serve as an important source of capital for rejuvenating failed depository institutions.  While some of the FDIC’s concerns are well taken, and the language used by regulators in the release and accompanying statements appears balanced and open to public input, it seems counterproductive to treat private equity investors so differently from other — presumably depository institution — bidders or to treat private equity acquisitions of "failed" banks so differently from acquisitions of banks that have not been seized, particularly those that might be financially troubled but not yet seized.

 [1]  Dan Primack, Wilbur Ross: FDIC Meeting Was "Highly Productive" peHUB, July 6, 2009, http://www.pehub.com/43866/wilbur-ross-fdic-meeting-was-highlyproductive/.

 [2]  Consider also the failure of J.C. Flowers’s bid for BankUnited, which we now understand failed at least in part because the private equity syndicate requested an alteration of the standard loss sharing agreement to add certain rights to transfer assets without FDIC consent.  See Gibson, Dunn & Crutcher client alert of July 1 [Release of BankUnited Bid Forms Shows Complexity of FDIC Decision Process] discussing this failed bid.

[3]  Some of the FDIC proposals may be open to alternative interpretations.  The proposed cross guarantee provision, for example, suggests the owners of a majority of the investments in more than one insured depository institution will be expected to pledge their proportionate interests in each institution in the case any of the institutions they own fails.  However, an alternative might be to have the guarantee apply only where it is the newly acquired depository institution that fails.

[4]  The tier 1 leverage ratio, considered an institution’s core capital ratio, is the ratio of total equity capital (with adjustments for unrealized gains and losses on securities, deferred tax benefits, non-qualifying preferred stock and other items) divided by average total assets.   

[5]  The firms acquiring BankUnited, for example, agreed to inject $900 million of capital into the troubled thrift.

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn attorney with whom you work or any of the following:

Dhiya El-Saden – Los Angeles (213-229-7196, [email protected])
Kimble C. Cannon – Los Angeles (213-229-7084, [email protected])
Stewart L. McDowell – San Francisco (415-393-8322, [email protected])
Douglas D. Smith – San Francisco (415-393-8390, [email protected])
Howard B. Adler – Washington, D.C. (202- 955-8589, [email protected])
Christopher J. Bellini – Washington, D.C. (202-887-3693, [email protected])
Michael D. Bopp – Washington, D.C. (202-955-8256, [email protected])

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