Troubled Banks and Failed Banks: Opportunities for Investment BRIAN W. SMITH AND MELISSA R. H. HALL This article highlights some of the relevant Federal Deposit Insurance Corporation policies and practices and issues for investors to consider before they embark on providing capital to a troubled bank or acquiring a failed bank or its assets. The prolonged distressed credit market crisis has already claimed several banking institutions which were declared insolvent and placed into receivership by the Federal Deposit Insurance Corporation ( FDIC ). Other banking institutions are suffering significant liquidity, asset valuation, and accounting concerns which have required them to raise additional capital. In some instances, banking organizations that raised enormous amounts of capital only months ago have been forced to raise even more as these organizations make ongoing adjustments in their balance sheets. Regulators have played significant roles in demanding that these institutions shore up their capital base. Despite the regulatory pressures and the injection of capital into many troubled and financially stressed banking institutions, there remains the very real possibility that there will be a marked increase in bank failures, especially among the mid to small banks which have been focused on the Brian W. Smith is a partner in the Finance Department of Latham & Watkins LLP, located in the firm s office in Washington, D.C. He can be reached at brian.smith@lw.com. Melissa R. H. Hall, an associate in the firm s office in Washington, D.C., can be reached at melissa.hall@lw.com. 483
PRATT S JOURNAL OF BANKRUPTCY LAW real estate sector (primarily residential development but now increasingly pure commercial as well). The FDIC has announced that it is gearing up for a dramatic increase in bank failures by recruiting for its resolution and receivership division and by bringing out of retirement 25 failed bank resolution experts. 1 Both the regulatory pressure on financially stressed banks to raise more capital and the expected marked increased in bank failures present investment opportunities. This is to be expected since during past crises many acquirers obtained significant benefit from such acquisitions. This article is designed to highlight some of the relevant FDIC policies and practices as well as to identify issues for investors to consider before they embark on providing capital to a troubled bank or acquiring a failed bank or its assets. BANK FAILURES AND THE ROLE OF THE FDIC When a bank fails, it is either declared insolvent by its primary regulator or the FDIC terminates the bank s deposit insurance. In either case, the FDIC steps in as receiver of the failed bank. The FDIC s statutory mandate is two-fold: (1) to guarantee eligible insured deposits and (2) to dispose of the failed bank and/or its assets with the least cost to the deposit insurance fund. 2 As part of that process, the FDIC has the authority to assert cross-guarantee claims against solvent banks in a multi-bank holding company setting, ostensibly to bolster the financial stability of an insolvent bank in that structure but with the effect of involving all the banks in the resolution process. 3 The FDIC resolution process is typically triggered by a bank s primary regulator sending a failing bank letter to the FDIC notifying the FDIC that the bank is in imminent danger of failing. Once it receives the letter, the FDIC will send a team into the bank to marshal all of the bank s assets, identify its liabilities, and value the assets. The FDIC typically has three options to regarding a failing bank: (1) sell all or a part of the failing bank to another bank which assumes the liabilities (including deposits) of the failed bank; (2) pay off all eligible insured depositors and sell the failing bank s assets; or (3) utilize the bridge bank structure (in 484
TROUBLED BANKS AND FAILED BANKS: OPPORTUNITIES FOR INVESTMENT which the Office of the Comptroller of the Currency charters a bank for the sole purpose of continuing temporarily the operations of the failing bank until it is sold) and sell the bridge bank to an acquirer. 4 Based on its assessment of the failing bank and its assets, the FDIC will decide whether to market the bank as a whole (while possibly retaining some less-desirable assets) or to divide up and sell the failing bank s assets. In either case, the FDIC prepares an information package for marketing the bank or its assets to potential acquirers. The FDIC s objective is to maximize its recovery so as to minimize the exposure to the deposit insurance fund. The FDIC typically conducts an auction-like process requiring approved interested parties to execute confidentiality agreements in order to obtain access to the marketing information package prepared by the FDIC. The FDIC will hold an information meeting with all approved bidders where the FDIC will provide details on the failing bank, whether the entire bank or just some of its assets is being offered for sale, the legal documents, the due diligence process, and the bidding procedures. Those parties with genuine interest are provided an opportunity for limited diligence of the marketing information package. In the past where the FDIC has decided to sell off bank assets rather than to market the bank as a whole, the FDIC grouped into one offering the assets from several failed institutions and routinely accepted bids for portions of such assets from several buyers. Also, to encourage the purchase of these assets, the FDIC may agree to loss-sharing arrangements whereby both it and the purchaser share the risk of ongoing losses in the purchased assets. It is important to note that the failing bank is still operating during this time and the FDIC takes great care to keep confidential the names of banks that are the subject of these resolution processes. Once a bidder is chosen and approved by the FDIC and all the legal documents are signed, the failing bank s chartering authority will close the bank and appoint the FDIC as receiver. This typically happens on a Friday in order to give the FDIC time to settle the affairs of the bank over the weekend. If the failed bank has been acquired in whole or in part, it will typically open for business and resume normal operations on Monday morning. If the assets of 485
PRATT S JOURNAL OF BANKRUPTCY LAW the failed bank are being sold off, the bank will remain closed and the assets will be transferred to the acquirer or acquirers. INVESTMENT BY NON-BANKS As mentioned above, there has been a marked increase in regulatory pressure on bank to raise additional capital. To date, capital raising has been facilitated by vast injections from private equity, foreign investors (even sovereign funds) and other alternative investment sources which traditionally had not been as readily available for this type of investment. To be sure that such investments or acquisitions of institutions or assets have a high likelihood of success, they must be properly structured to comply with long standing, though currently evolving, regulatory restrictions on ownership and control of U.S. banks. Prior evaluation of the investor s situation and how it might be adapted for the purpose of acquiring U.S. banks is necessary, as eligibility to actually control and operate a bank is a critical qualification to a successful bid at the FDIC. The primary issues to consider when making an investment in a troubled bank or purchasing a failed bank center around the concept of control. Under the Bank Holding Company Act, any company that directly or indirectly controls a bank is deemed a bank holding company and is subject to restrictions on non-financial activities (i.e., commercial activities and investments are prohibited), capital and other requirements, and periodic reporting to and examination by the Federal Reserve. An investor can be found to be in control of a bank with as little as 10 percent ownership of any class of voting stock. Even with an investment below the 10 percent threshold, the Federal Reserve may find that the investor controls the bank if the investor controls the board or has other influence over the day to day activities of the bank. An investment of less than five percent of a class of voting shares of a bank is presumed under federal banking regulations not to result in control of the bank. If the investor wishes to hold a greater percentage of any class of voting stock, it is possible to structure the transaction so that the regulators will not consider the investor to be in control of the bank. These structures typically involve passivity commitments on the part of the investor 486
or the placing of the stock in a trust subject to the control of an independent voting trustee. It is also may be possible to disperse the investment among unaffiliated investors so that each will control less than 10 percent of a class of voting stock and agree not to act in concert with regard to the operation of the bank. Any structures developed to avoid a finding of control will have to be carefully planned and considered, as the banking regulators retain discretion to find that an investor is exercising control over a bank. CONCLUSION Although there are expected to be increased investment opportunities for those wishing to invest in banks or purchased a failed bank or the assets of a failed bank, there are numerous issues for investors to consider in connection with such transactions. Investors would be well advised to: (1) become familiar with FDIC resolution processes for failed banks; (2) communicate to the FDIC its general interest in being considered a potential purchaser of a failed bank or its assets; (3) establish an effective diligence and bidding process and team; and (4) structure any acquiring or investment vehicle in a manner that will both clear any regulatory hurdles, especially if the investor s primary business line is commercial and not financial in nature. NOTES TROUBLED BANKS AND FAILED BANKS: OPPORTUNITIES FOR INVESTMENT 1 Damian Paletta, FDIC Readies for a Rise in Bank Failures, Wall St. J., February 26, 2008, at A2. 2 12 U.S.C. 1821(d); 12 C.F.R. 360.1. 3 12 U.S.C. 1815(e). 4 12 U.S.C. 1821(n). 487