Private Equity Investments In Troubled Banks

Originally published July 15, 2009

There has been increasing pressure on banks to increase their equity capital levels (and decrease their leverage ratio) in response to losses caused by declines in asset values. Historically, U.S. bank regulatory policy has limited the sources of equity capital that were available to banks, as policymakers have considered it essential to maintain the separation between the activities of banking and of commerce, even if that meant depriving banks of the potential for raising equity from private institutional investors. Recently, this policy has come under scrutiny and the federal banking regulators have considered whether commercial investors, particularly private equity funds ("PEFs"), might be induced to contribute capital and management expertise to failing (and already failed) banks.

Notwithstanding the desire to encourage investment in banks, the banking regulators are demonstrating an ambivalence about private equity investments in failing banks. The "shelf charter" offered by the Office of the Comptroller of the Currency ("OCC") appeared inviting to non-bank investors that might seek to acquire the assets and deposit liabilities of failed institutions, but the private equity investment guidelines recently proposed by the Federal Deposit Insurance Corporation ("FDIC") would impose enhanced capital requirements and restrictive investment commitments likely to discourage PEF investment. Meanwhile, the Board of Governors of the Federal Reserve System ("Board") has struck somewhat of a middle ground, liberalizing the definition of "control" for Bank Holding Company Act "(BHC Act")1 purposes, while affirming and increasing the burdens imposed on owners that do exercise control over a bank.

In sum, the regulators' responses to private equity proposals to invest in failing banks have been mixed, with the Board's Policy Statement seeking to facilitate passive investment in banks by PEFs, the OCC's Shelf Charter pre-approving PEFs to become BHCs, and the FDIC's Proposed Guidelines hesitantly welcoming "club" PEF acquisitions of the assets and liabilities of failed banks, while imposing capital and transfer restrictions that may make the welcome seem rather chill. An overview of each of these measures is provided below.

1. THE BOARD'S POLICY STATEMENT AND THE BANK HOLDING COMPANY ACT Historically, the primary obstacle to a PEF taking a significant ownership interest in a bank has been the BHC Act and Regulation Y thereunder,2 which restricts the activities of companies that "control" banks to activities that are either "so closely related to banking as to be a proper incident thereto" or, in the case of a PEF that has qualified as a financial holding company, "financial in nature."3 A PEF subject to the BHC Act would be deemed to be engaged in any activity carried out by the portfolio companies that the PEF controls. Thus, a PEF subject to the BHC Act would be prohibited from "controlling" any portfolio company engaged in any activity that is not "closely related to banking" or "financial in nature" within the meaning of the BHC Act.4 In addition, all BHCs are themselves subject to capital requirements that might further restrict asset allocation at the holding company level.

   Because the definition of "control" is key to application of the BHC Act, the Board has defined "control" very broadly to create broad coverage for the statute. The BHC Act defines "control" as direct or indirect ownership of, control of, or holding with power to vote, 25% or more of a class of voting securities of a commercial bank, or the ability to determine the election of a majority of directors.5 In addition to these largely numeric tests, the Board has promulgated a more open-ended subjective test: an entity will be deemed to be a BHC if it can exercise a controlling influence over the management or policies of a bank.6 The holder of securities is deemed to "control" anything that any firm it "controls" in turn "controls."7

   Under this more subjective test, the Board in Regulation Y has indicated that "control" of a bank can be created with ownership of as little as 5% of a class of voting securities, at least where there are any management or director interlocks between the bank and the owner and no one else owns more than 5% of the bank. Further, in 1982, the Board issued a policy statement on nonvoting equity interests in BHCs that, in essence, suggested that control could arise through ownership of nonvoting securities if an investor owned or controlled nonvoting securities that represented 25% or more of the bank's equity.8

   That said, it is certainly possible for a PEF to invest in a bank or BHC without triggering a determination of "control." Limiting the investment to preferred nonvoting shares that represent less than 25% of equity or less than 5% of a class of voting securities will avoid a finding of "control" unless other "indicia" of control exist.

   In addition to "control" through ownership, "control" may also be found to arise from contracts that confer rights on the PEF that would normally accompany voting share ownership (e.g., a right to prohibit a merger without the PEF's approval) or that substantially limit the authority of the bank's management to make decisions (e.g., a right to prohibit the...