In the wake of the Dodd-Frank Act, continuing regulatory pressure on financial institutions and the destabilized real estate market will continue to require a significant number of recapitalizations of banks.
The bank recapitalization process has been anything but simple as a result of the regulatory requirements that have been imposed, particularly on private investors. But, in response, a variety of structures have been developed to accommodate the interests of banks, their investors and regulators, and significant transactions have been closed, establishing new precedents.
As always, the race for this new capital will be won by banks and investors that understand the process and recognize what regulators are looking for.
An important issue for investors and regulators is the quality of the management team that will run the bank. A close second is the nature and quality of the business plan. It must reflect current business realities as well as regulatory policies.
For example, plans that focus on commercial real estate, subprime mortgages, niche lending or wholesale funding will not pass regulatory muster in the risk-adverse environment that we are in.
The nature and quality of new capital is important in an environment where regulators are skeptical about the intentions of private-equity and hedge fund investors. In that regard, the reputation of the investors, their knowledge and experience in regulated financial services and their willingness to comply with regulatory limitations that are intended to ensure that investors are passive and are not acting in concert with one another are critical.
Generally, investors will want to avoid holding company status, so there will be much back-and-forth between investors and the Federal Reserve Board regarding the need to file a change-in-control application, the execution of passivity commitments and nonaffiliation certifications and the need for information about the investor funds and their investors. This process is usually a negotiated give-and-take, and it can affect the timing of a transaction.
The type of investment and the structure of the acquiring entity will also generate a wide range of regulatory, governance, tax and other issues.
The structures in use today include: a direct investment in the holding company of a bank; a direct investment in the subsidiary bank of a holding company; a prepackaged bankruptcy recapitalization of the holding company; and a sale out of bankruptcy under Section 363 of the Bankruptcy Code.
Recapitalizations may involve a single investor or multiple investors through a club structure or blind pool arrangements. The structure that is selected is often dictated by the presence of holding company trust-preferred securities, debt holders and other financial issues. Complications also arise if the bank still has Troubled Asset Relief Program funds and the Treasury Department is a party to the transaction.
Closely aligned to issues related to control is the extent of investor representation on the board of directors of the recapitalized holding company or subsidiary bank. Investors that execute passivity commitments may have one board representative, a nonvoting observer and, in certain limited cases, a second director on the board. The specific manner in which those seats are allocated, locked in and memorialized in the governing documents is important in order to pass regulatory muster.
It should be noted that, while investors with less than 5% of the voting shares of a holding company or bank generally will not be subject to the majority of regulatory requirements, they will be subject to the Federal Deposit Insurance Corp.'s Statement of Policy on Acquisitions of Failed Banks if they have any board representation. Many private-equity investors seek to avoid the Statement of Policy because of its requirements regarding the holding period of the fund's investment and restrictions on the use of foreign funds.
Banks need to be honest and direct with prospective investors about their regulatory issues. Naturally, they tend to be upbeat about their relationship with their regulator, even when they have outstanding enforcement actions. So, investors must maintain a degree of skepticism.
While the existence of enforcement actions is not the most inviting circumstance in which to attract new capital, it is not necessarily a deal killer in the current environment, largely because so many banks have outstanding enforcement issues.
The key for investors is to gain a clear understanding of what the enforcement actions require of the bank and to have frank discussions with regulators, to the extent they are willing to engage in such discussions, about what it will take to have the actions or orders lifted.
For example, if a cease-and-desist order is fundamentally about the need to raise new capital, a recapitalization may address regulators' concerns and obviate the need for a continuing order. However, where there are also significant management, asset-quality, lending, governance, liquidity or other issues included in the order, a recapitalization alone is not likely to convince regulators to terminate the order before the next examination cycle.
In short, the bank and its investors will want to ensure from an early point in the negotiations that the regulators are on board with the transaction and any controversial terms it may include. It will be damaging and expensive for both sides to pursue a recapitalization that cannot obtain regulatory approval.
Investors need to be well advised in bank recapitalization deals and to understand the requirements that regulators will impose.
