Several recent transactions by private-equity investors, such as the HSH Nordbank deal led by the J.C. Flowers Fund and the Doral Financial Corp. deal led by Bear Stearns Merchant Banking, highlight the newly discovered interest of private investors in federally and state-regulated financial institutions.
A Viewpoint by OTS Director John Reich ["
Director Reich could not have been more on target in terms of identifying the issues that private-equity firms must consider when evaluating investments or acquisitions in the financial services industry.
In the banking world, concepts of control often have little to do with the ability to exercise actual control over an institution. Control (indirect as it may be) can arise, for example, by virtue of an investment in more than 10% of a class of voting securities of a company that owns 35% of another company's voting stock, which, in turn, owns more than 25% of a bank or thrift institution's voting stock.
The four 'A's of stock ownership — "aggregation, attribution, acting in concert, and affiliation" — are critical components when evaluating the existence of control and the ways that the chain of control can be affected under federal and state law.
We have entered — whether temporarily or permanently — a new period of bank and thrift acquisitions in which deal architects will have to balance the complex federal and state rules governing what constitutes voting control of a bank, when holding company rules are triggered, and how affiliated transaction limitations may impact the deal and its equity investors.
An investment in or acquisition of some or all of the voting stock of a regulated financial institution and/or the companies that control it can be completed without triggering either control or holding company requirements, but the restrictions of the law may suggest an investment profile that does not always reflect that of the typical private-equity investor.
For example, voting control generally would have to be limited or dispersed among a number of investors to avoid a determination of control by any one investor or group of investors acting in concert. Otherwise, an investor may be considered a holding company, which would trigger investment, activity, affiliate, capital ratio, and other restrictions, as well as potential obligations to infuse additional capital that it may not be able to operate under.
Thus, the voting interests of private-equity investors would have to be kept below 10%, and the investors would have to agree not to act in concert to influence or control the bank or its holding company after the acquisition. In that regard, investors that do exceed 10% of the voting stock may be required to (i) execute passivity agreements in which they give up the right to influence the management of the parent company or subsidiary bank, (ii) waive rights to put representatives on the board of directors, or (iii) forego the right to conduct a proxy contest.
Alternatively, nonvoting and other convertible instruments such as preferred stock, options, rights, and warrants can be utilized to provide investors the economic interest they desire. But such instruments may be treated like voting securities if they are immediately convertible at the time they are issued, the holder is vested with the preponderant economic risk in the underlying voting stock, or in the aggregate they equal more than 25% of the total equity of the institution or its holding company. These standards are interpreted somewhat differently by the various federal banking agencies.
Some transactions have utilized voting trustees who can step into the shoes of equity holders and shield the investors from the consequences of control under federal and state banking laws. Such voting trusts usually preclude the voting influence of beneficiaries and limit their ability to remove the voting trustee.
Alternative escape valves exist for financial institution investors who ultimately find themselves in too restrictive a position to adequately protect their interests. They can file for a change of control so that they can purchase additional voting stock, conduct a proxy contest for board seats, or purchase the entire bank or holding company, but they then may have to live under bank or savings and loan holding company restrictions.
Naturally, they can always sell some or all of their position to get below various control thresholds, but since the market may not always be kind to the timing of such sales, investors should understand the restrictions that could apply and know what their exit strategies are before they proceed down the path of investing in or controlling a regulated financial institution.
