RECAPITALIZATION AND ACQUISITION OF FINANCIAL INSTITUTIONS: EVOLVING STRUCTURES AND REGULATORY GUIDANCE

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1 RECAPITALIZATION AND ACQUISITION OF FINANCIAL INSTITUTIONS: EVOLVING STRUCTURES AND REGULATORY GUIDANCE February 2012 EAST\

2 INDEX Section Page I. INTRODUCTION... 1 II. STRUCTURING ALTERNATIVES FOR BANK RECAPITALIZATIONS Investments into Bank Holding Companies Investments Directly into Banks that are Subsidiaries of Bank Holding Companies... 4 A. Good Bank / Bad Bank Structures... 5 B. Bank Acquisitions as Part of a Section 363 Reorganization of the Bank Holding Company... 7 III. KEY REGULATORY CONCERNS Principal Regulators and Their Roles Control and its Definition Cases Where Prior Approval Will Be Required Irrebuttable Presumptions of Control Cases Where Prior Approval May Not Be Required Rebuttable Presumptions of Control and CIBCA Filings Safe Harbor No Prior Approval Necessary IV. REGULATORY ISSUES IN STRUCTURING INVESTMENTS Acting in Concert and its Consequences Rebutting Control / Passivity Commitments Consequences to an Investor of a Finding of Control FDIC Statement on Failed Bank Acquisitions APPENDIX A OVERVIEW OF KEY THRESHOLDS FOR CONTROL UNDER THE FEDERAL BANKING LAWS APPENDIX B THE FDIC S STATEMENT ON FAILED BANK ACQUISITIONS

3 RECAPITALIZATION AND ACQUISITION OF FINANCIAL INSTITUTIONS: EVOLVING STRUCTURES AND REGULATORY GUIDANCE FEBRUARY 2012 I. INTRODUCTION As depository institutions have attempted to recapitalize, they have found the path to success difficult due to increasingly pessimistic investor sentiment about the near-term prospects for the banking market. In addition to a host of market and macro-economic reasons for this sentiment, many investors who have traditionally looked to recapitalize depositories through an investment in the holding company have found that liabilities at the holding company, whether litigation-related or in the form of outstanding debt instruments or trust preferred securities, are a significant impediment to the investment. In situations where investors are willing to make an investment through a bank holding company (BHC), such a transaction is often highly dilutive to the BHC s existing stakeholders, including creditors, shareholders, and trust preferred securities holders, which makes it difficult for a BHC to garner the requisite support from its existing stakeholders for the transaction. Even BHCs that have the support of their existing stakeholders are finding it increasingly difficult to consummate highly dilutive transactions because potential investors do not see the desired level of investment returns as their investment effectively recapitalizes, at least in part, existing liabilities of a BHC. Similarly, a proposed acquirer of a BHC with a subsidiary bank in need of recapitalization will substantially discount the amount it is willing to pay the target BHC s shareholders due to the substantial stake that creditors and trust preferred securities holders have in the target BHC. These discounts often make it difficult for a BHC to seek the approval of its shareholders for such a sale. Furthermore, even if a BHC desires to negotiate a discount with its trust preferred securities holders, many are unable to do so as these holders are very difficult, if not impossible, to ascertain and contact. Many of the trust preferred securities that were issued in the five plus years leading up to the financial crisis were sold to alternative investment vehicles that packaged the trust preferred securities and sold securities with various maturity terms and distribution rates to investors based on the underlying trust preferred securities. These securities are commonly known as collateralized debt obligations, or CDOs. Often, once the CDOs were sold, the sponsor would no longer actively manage the assets underlying the CDOs (i.e., the trust preferred securities) and, therefore, no longer have the ability to negotiate the terms of the trust preferred securities on behalf of the CDO holders. Alternatively, the terms of the CDOs do not permit the issuers of the trust preferred securities holders to have access to the CDO holders. 1

4 Accordingly, if bank recapitalization investments are structured at the holding company level, holders of debt instruments and trust preferred securities would not suffer dilution comparable to the dilution that the common shareholders would experience and therefore would, in essence, be fully recapitalized. This materially lessens the return to investors, most often making the investment altogether unattractive. Similarly, financial institutions looking to acquire depositories by means of an acquisition of their holding company are often unwilling to assume the liabilities of the target BHC. As a consequence, investors and financial institutions alike are increasingly interested in pursuing a recapitalization of the depository institution directly at the bank level or, more aggressively, purchasing the stock of the bank through a bankruptcy of the holding company by means of a Section 363 reorganization. Against this backdrop are the evolving regulatory standards for investments in depository institutions. Most of such investments are structured by investors (whether acting as individual investors, in conjunction with a group of other investors, or as part of a fund structure) as non-control investments. Typical structures that are used are becoming more of a well-worn path for regulators as private sources of capital have played a significant role in recapitalizing the banking industry over the past several years. Regulatory positions and standards for non-control investments are evolving rapidly in the current economic cycle as an increasing number of significant non-control investors assess opportunities that are presented when banks seek capital infusions. This article sets forth the latest insight into the evolving structural and regulatory considerations that are applicable to bank and BHC recapitalization transactions. II. STRUCTURING ALTERNATIVES FOR BANK RECAPITALIZATIONS While there are many different structures that can be employed depending on the specific facts and circumstances of any given recapitalization transaction, there are two broad categories of structures that have very different considerations. Those categories are investments at a BHC level and investments directly into a bank which has an existing BHC parent. Those structures, and a few significant permutations of each, are discussed in this Section II. 1. Investments into Bank Holding Companies A traditional recapitalization transaction for a bank that is a subsidiary of a BHC is, of course, for the holding company to issue securities to investors, raise capital, and downstream some or all of the net proceeds to the subsidiary bank. This type of transaction is the structure that regulators expect and it is generally their objective when they direct troubled institutions to raise capital. From a strictly regulatory perspective, BHC-level investments are tried and true and often do not raise special regulatory considerations beyond those arising in the context of control and acting in concert determinations 2

5 discussed in Section III Key Regulatory Concerns and Section IV Regulatory Issues in Structuring Investments. In part, the regulatory bias toward BHC investments is because the vast majority of banks are subsidiaries of BHCs. In fact, the Federal Reserve s Partnership for Progress indicates that [c]urrently, about 84 percent of commercial banks in the U.S. are part of a BHC structure. More than 75 percent of small banks with assets of less than $100 million are owned by BHCs; this percentage increases to 100 percent for large banks with more than $10 billion in assets. 1 But the structure also has served as a traditional means of recapitalizing institutions because the regulators, particularly the Board of Governors for the Federal Reserve System (the Federal Reserve), prefer that the recapitalization take place at the holding company so that the BHC can continue to serve as a financial and managerial source of strength for the subsidiary bank in the future notwithstanding the reality that many BHCs are so significantly distressed that they cannot legitimately serve as a meaningful source of strength. Moreover, while not an official policy, the Federal Deposit Insurance Corporation (the FDIC) has suggested in reviewing specific applications that it prefers the investment to be made at the holding company level so that all stakeholders are recapitalized. This is particularly true if the BHC has outstanding trust preferred securities as such securities are often held by other depositories. While the FDIC readily admits it has no jurisdiction over BHCs, it justifies its view due to its natural concern about the overall health of the banking system. From a fiduciary perspective, management of a BHC may also be pressured to seek recapitalization at the holding company level so as not to dilute the BHC s ownership of the subsidiary bank and to ensure that all stakeholders are, in effect, recapitalized. Additionally, a BHC can issue debt securities as a form of less expensive capital relative to equity, and downstream the proceeds of those debt securities into the subsidiary bank as Tier 1 capital. We note that the Collins Amendment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), enacted into law on July 21, 2010, imposes risk-based and leverage capital standards on BHCs consistent with those currently applicable to insured depository institutions. While the Collins Amendment eliminates Tier 1 capital treatment for BHC-issued trust preferred securities and other hybrid debt and equity instruments, that option remains for certain small BHCs. To the extent that a BHC has less than $500 million in assets and therefore is not subject to the Federal Reserve s Small Bank Holding Company Policy Statement, debt or hybrid instruments may serve as a less expensive way to provide capital to the subsidiary bank if, in fact, credit is available for the BHC. 1 Source: 3

6 Investors historically preferred investing at the holding company level because the BHCs are created under state corporate codes rather than banking statutes and provide greater specificity and flexibility to the rights and preferences of security holders at the BHC level. As economic conditions have deteriorated over the last five years, many BHCs have amassed various liabilities at the BHC level, and as described below, the preference to invest directly into the BHC is no longer a given. 2. Investments Directly into Banks that are Subsidiaries of Bank Holding Companies In today s environment, many BHCs are not in a financial position to serve as a source of strength for their subsidiary banks. Many have amassed significant liabilities in prior efforts to financially strengthen their subsidiary banks or have substantial outstanding hybrid debt and equity securities in the form of trust preferred securities, likely issued many years prior, and often in CDOs where the actual owner or holder of the securities is difficult to identify. As the financial condition of a bank and BHC declined, many were prohibited from making periodic dividend payments on trust preferred securities and, as a result, holders of such trust preferred securities are owed dividend payments from prior quarters in amounts that, in aggregate, can be daunting. In some cases, these liabilities are sufficient to deter investor interest in a recapitalization transaction at the BHC-level notwithstanding the fact that the subsidiary bank may have substantial franchise value. These factors, which appear to exist in a number of banking organizations in the current environment, have resulted in efforts to recapitalize a subsidiary bank by investing directly in the bank and diluting the ownership interest of the BHC in its subsidiary bank. From a regulatory perspective, these types of transactions are viewed as potentially novel and raise unique considerations, some of which are discussed below. De-registration of a Bank Holding Company. As noted, a BHC s interest in a subsidiary bank is necessarily diluted when investors invest directly at the bank level. Pricing, the amount of capital needed and the financial condition of the subsidiary bank lead to complicated discussions among the BHC and investors as to exactly how much dilution the BHC must assume. Possibly in an effort to escape enforcement orders from the Federal Reserve and then be permitted to make payments on outstanding liabilities, including trust preferred securities, or perhaps due to the severity of the financial troubles experienced by the subsidiary bank, some BHCs may be so significantly diluted in a proposed transaction that they may not be in a control position for the bank following the transaction. Generally, one would expect that a BHC looking to de-register as a BHC to follow the same standards and guidelines discussed herein for bank investors. However, the Federal Reserve has not previously accepted a de-registration of a BHC that reduces its ownership interest in a subsidiary bank but retains a non-control position. We understand that the Federal Reserve s general position is that de-registration may be accomplished only if the BHC retains less than 5 percent of the voting interest in the bank and does not have ongoing shared management or other relationships with the 4

7 bank. In essence, a BHC seeking to de-register must meet the safe harbor requirements for non-control of a bank as discussed herein and not be within the rebuttable range for control as a result of the transaction. Objections of Bank Holding Company Creditors. Third parties looking for repayment from a BHC may object to a proposed transaction that dilutes the BHC s relative ownership interest in the bank, sometimes merely as a means to gain information and may not realize the proposed transaction may ultimately benefit them as well. We note that publication of a notice or application with the bank regulatory agencies typically begins a formal comment period during which members of the public or interested parties may comment in favor of, or opposition to, a proposed transaction. Any meaningful, formal comments filed in opposition of a notice or application will often cause regulators to pause their review, and the agencies may in fact expect the applicant to vet the issues with commenters and report back on the outcome. Further, in the case of certain trust preferred securities issuances, the indentures related to such issuance may provide that a BHC s reduced ownership interest in the subsidiary bank is an event of default. Regulators are both aware of, and concerned about, potential litigation exposure and related costs for the BHCs (and potentially their subsidiary banks) as a result of transactions that dilute a BHC s ownership of its subsidiary bank.2 Within the broader category of bank-level investments, two specific structures appear to be gaining industry and regulatory attention and increasing in their consideration by investors and financial institutions alike. Those are good bank / bad bank structures and Section 363 reorganizations, each of which is discussed below. A. Good Bank / Bad Bank Structures Often, bank acquirers do not want to invest in, or acquire, a subsidiary bank that has a significant amount of non-performing loans and other real estate owned. Acquirers may attempt to solve this problem by agreeing to acquire the good bank through a purchase and assumption structure (similar to a branch acquisition transaction) and leave the bad bank in the subsidiary bank. This structure is possible if the acquirer is willing to assume all of the deposits of the subsidiary bank, which will allow the subsidiary bank to liquidate itself upon consummation of this transaction and to distribute the remaining assets (and liabilities) to the BHC. The BHC can then de-register as a BHC, sell or manage such assets, and attempt to satisfy the claims of its creditors as it winds down its operations. This structure is also possible where the subsidiary bank has an affiliate bank that can assume any remaining deposits as well as the remaining assets after the completed acquisition of the 2 By way of example, we reference the recent lawsuit filed by Hildene Capital Management in opposition to the proposed sale of BankAltantic from BankAtlantic Bancorp to BB&T Corporation announced on November 1, Hildene Capital Management purports to hold trust preferred securities of BankAtlantic Bancorp. 5

8 good bank. These transactions are often difficult to accomplish due to both valuation issues and regulatory concerns, but they are possible to complete. Other options available to recapitalize banks with a significant non-performing asset portfolio (through a sale of the bank or a direct investment in the bank) involve an asset sale of many, if not all, of the non-performing assets. This sale is usually conducted by a third party advisor for the bank and the non-performing assets must be sold at a discount to their thencurrent book value. Such a discount has an adverse impact on the capital of the bank and, therefore, the amount of this negative capital impact needs to be considered when the parties are deciding on the amount of capital to be infused as part of the bank investment. Regulators will closely review any scenario where the purchaser of the non-performing assets is either related to the bank, its management, or a proposed investor in the bank or otherwise exposes the bank to some ongoing economic risk for asset performance following the transfer. By way of example, the Office of the Comptroller of the Currency (the OCC) has issued guidance that affirmatively rejects structures where a bank distributes nonperforming assets in exchange for performing assets that are reliant on the original assets for their continued performance because the bank retains the risk of performance for the transferred assets.3 Another option is for the subsidiary bank to dividend many, if not all, of the non-performing assets to the BHC. Effecting such a dividend can have tax implications on both the subsidiary bank and BHC and requires that the transaction be structured in multiple steps for it to be tax efficient, including a purchase of subsidiary bank stock directly from the BHC by investors or an acquirer to provide the BHC with sufficient cash to manage the nonperforming assets until it is able to liquidate them. Bank regulators do not look favorably on this structure for a number of reasons, including that it appears to be a circumvention of the affiliated transactions rules with the economic result being the sale of assets to the BHC without consideration. However, this is not the case, as the BHC is agreeing to reduce its ownership in the subsidiary bank and receive non-performing assets (and some cash from investors) to allow the subsidiary bank to be recapitalized by the investors. In instances where the bank is in troubled condition and has an existing order with its regulators that prohibits dividends without regulatory consent, the bank will find it very difficult to convince the agencies to waive that restriction. Further, where the transaction involves a direct investment in the bank rather than an acquisition of the bank, regulators may not look favorably on this transaction structure as it leaves the subsidiary bank without a BHC to act as its source of strength. Notwithstanding these concerns, we believe that this transaction structure is viable in certain circumstances. 3 For example, see the OCC s CEO Letter, OCC , Exchanging Other Real Estate Owned for Other Assets (March 24, 2011). 6

9 B. Bank Acquisitions as Part of a Section 363 Reorganization of the Bank Holding Company Given the financial condition of certain BHCs and the difficulty of obtaining approval from all of a BHC s stakeholders, including shareholders, creditors and trust preferred securities holders, for transactions involving the structures discussed above, some investors may look to acquire a subsidiary bank through a transaction effected under Section 363 of the U.S. Bankruptcy Code as an alternative to a direct investment in, or acquisition of, a subsidiary bank from a BHC. A BHC that needs to recapitalize its subsidiary bank may, as a last resort, file for federal bankruptcy protection to facilitate a structured, court-approved sale of its subsidiary bank, and thereby avoid bank receivership and associated regulatory and civil liability considerations of a bank failure. The sale of a subsidiary bank by a BHC in a bankruptcy process eliminates the stigma of the subsidiary bank being placed in receivership and allows the purchaser to acquire the subsidiary bank free and clear of any outstanding claims and obligations against the BHC. Below we outline the process for a Section 363 transaction and discuss the benefits and considerations of this type of transaction for the potential participants. Mechanics of a Section 363 Transaction. Section 363 of the U.S. Bankruptcy Code is a broad provision that governs the use, sale, or lease of property held by the debtor (referred to as the debtor in possession ) during the pendency of a bankruptcy proceeding. Generally, the sale of a subsidiary bank will be considered a sale outside the ordinary course of business which, under Section 363(b), can occur only after approval by the bankruptcy court following notice and a hearing. A Section 363 transaction can be completed relatively quickly and, if approved by the bankruptcy court and the appropriate state and federal bank regulators, closing may occur as soon as 45 to 60 days after the bankruptcy filing. The ultimate disposition of the debtor s estate will take longer; however, the wind-down of the debtor is not the responsibility of an entity that acquires its subsidiary bank. Similarly, the bankruptcy process eliminates the risk of future claims by creditors or trust preferred securities holders of the bankrupt BHC against the acquirer or the subsidiary bank. There are seven significant steps in a Section 363 transaction, each of which is described below. First, the BHC identifies a stalking horse bidder to purchase the subsidiary bank. This process is typically accomplished in a manner similar to a traditional M&A sale process. The stalking horse bidder can be a BHC or a new entity formed by a management team or investors for the purpose of acquiring the subsidiary bank. For investors looking to participate in the acquisition of a subsidiary bank in a Section 363 transaction, it is easiest to do so through an entity specifically formed to act as the stalking horse bidder. Investors would make their investment in the subsidiary bank indirectly through this new entity. Without a new entity, investors would need to be separate stalking horse bidders for a portion of the subsidiary bank that would, for 7

10 all practical purposes, require the investors to act together to make a viable bid, which would give rise to acting in concert issues that investors typically want to avoid (see Section IV, 1 Regulatory Issues in Structuring Investments Acting in Concert and its Consequences for a discussion of these issues). Second, the stalking horse bidder conducts its due diligence on the subsidiary bank (and any other assets to be purchased from the BHC) and agrees with the BHC on the value of the subsidiary bank (and any other assets it intends to acquire from the BHC). Third, the BHC and the stalking horse bidder negotiate and enter into a purchase agreement for the subsidiary bank, contingent on all necessary bankruptcy court and regulatory approvals. The purchase agreement will set forth the purchase price to be paid to the BHC for the subsidiary bank s common stock (and other assets to be purchased) and the equity contribution from the stalking horse bidder to recapitalize the subsidiary bank. Given the nature of a Section 363 transaction and the expectation that the BHC will not survive the 363 transaction as a going concern, the purchase agreement typically has more limited representations, warranties, and covenants than a standard acquisition agreement. The purchase agreement may include a break-up fee guarantee that protects the stalking horse bidder in the face of competing bids during the auction process for the bank required to confirm fair value as part of a bankruptcy proceeding. Additional terms in a typical Section 363 purchase agreement include expense reimbursement for the stalking horse bidder and minimum bid increments and deadlines for competing bids, all of which serve to protect the stalking horse s interest and reimburse the stalking horse for costs in the event another bidder successfully obtains the bank. The bankruptcy court will need to approve the final purchase agreement, along with terms of the bidding process. The stalking horse bidder has advantages over other bidders, as other bidders will have a limited timeframe to conduct due diligence and offer competing bids and generally must bid based upon terms of the stalking horse bidder s purchase agreement. Fourth, the BHC files for bankruptcy protection and immediately files a motion for an order approving the bidding procedures for the auction of its subsidiary bank, setting forth the terms and conditions of the purchase agreement with the stalking horse bidder. Fifth, the stalking horse bidder files for bank regulatory approval to acquire the subsidiary bank and the BHC files for all regulatory approvals necessary for the sale under any of its enforcement actions or letter agreements with the applicable bank regulators. In addition, if the stalking horse bidder is a new entity, investors in the new entity may be required to make certain filings with the applicable bank regulators (see Section III Key Regulatory Concerns for the potential filings that investors may be required to make). 8

11 Sixth, the bidding procedures are approved by the bankruptcy court and the bidding process is opened to other bidders who may conduct due diligence and make competing bids on the BHC s assets. The bidding process typically takes 30 to 45 days. Seventh, the sale is approved by the applicable bank regulators and the bankruptcy court. Approval by the bankruptcy court under Section 363 will transfer the stock of the subsidiary bank (and other assets purchased from the BHC) to the winning bidder free and clear of any claims, liens or encumbrances of the BHC. No approval of the BHC s shareholders or debt holders is necessary to approve the Section 363 sale transaction. Benefits of a Section 363 Transaction. The benefits of a Section 363 transaction for the BHC include allowing the BHC s board of directors to obtain comfort as to the fairness of the purchase price for the subsidiary bank through bankruptcy court approval of the Section 363 transaction and obtaining releases through the sale process and the ultimate plan of liquidation of the BHC. In addition, the BHC can effectively recapitalize the subsidiary bank without the receivership. The benefits of a Section 363 transaction for the acquiring entity include allowing the entity to dispose of executory contracts to which the BHC is a party, and potentially receive favorable treatment of net operating losses associated with the subsidiary bank under Section 382 of the Internal Revenue Code due to the application of Section 382(l)(6), which values the loss corporation (i.e., the subsidiary bank) postrecapitalization, thereby materially increasing the utilization of net operating losses which can be applied to the acquirer s consolidated income. The sale of a subsidiary bank through a Section 363 transaction is, currently, a highly unusual transaction for BHCs and subsidiary banks. As a result, all participants in the process should engage in dialogue with the applicable bank regulators early enough in the process to determine if the bank regulators will be supportive of the transaction. In addition, through dialogue and meetings with the bank regulators, the participants can ascertain the specific approvals that the bank regulators will require the participants to obtain prior to consummation of a Section 363 sale transaction and hopefully get some sense of the timeline available to execute the transaction before the bank is placed into receivership. Ultimately, if a Section 363 transaction is successfully consummated, it can be done expediently and can recapitalize a bank that otherwise may not be recapitalized due its BHC s inability to otherwise raise capital or sell itself. 9

12 III. 1. KEY REGULATORY CONCERNS Principal Regulators and Their Roles The Federal Reserve regulates BHCs and state-chartered banks electing to be Federal Reserve member banks. The FDIC regulates state-chartered banks that do not elect to be Federal Reserve member banks. The Dodd-Frank Act transfers responsibility for the regulation of savings and loan holding companies to the Federal Reserve from the Office of Thrift Supervision (the OTS) as of July 21, 2011, the transfer date. As of the transfer date, the role of the OTS was completely absorbed by other banking regulators. Federally chartered thrifts, previously regulated by the OTS, are now regulated by the OCC, the agency that also regulates national banks. State-chartered thrift institutions are now regulated on a federal level by the FDIC. A corporation, fund, trust, or other entity that considers an investment in a bank must assess potential BHC status under the Bank Holding Company Act (the BHC Act) or, in the case of thrift institutions, the Home Owners Loan Act (the HOLA), in each case as interpreted and applied by the Federal Reserve.4 If an individual, rather than an entity, seeks to make a significant investment in a bank, a comparable review by the primary bank regulator under the Change in Bank Control Act (the CIBCA) will also be required. The Federal Reserve will make the CIBCA control determination in cases where the investment is made at the holding company level.5 To the extent an investment is made directly into a bank and not into a holding company, the primary regulator with jurisdiction over the bank will make the CIBCA control determination. Regulatory determinations concerning these issues will turn on critical relevant factual and financial considerations, and are therefore often difficult to predict with certainty without specific review of the facts and circumstances present for a given investment. That said, useful guidance is available from these agencies on the regulatory and legal standards applied in their analyses, and should be thoughtfully considered by investors or investor groups when approaching a proposed investment. The Federal Reserve reviews carefully every proposal by an investor to acquire control of a bank or BHC, and similarly reviews significant non-controlling investments to ensure that the investor will not be in a position to exercise a controlling influence over management or policies of the bank. The process can be detailed and lengthy; in the case of a finding of control a BHC application will be required that is not typically subject to expedited review and may not be subject to delegated review at the District Reserve Banks of the Federal 4 5 Relevant change of control statutes, under state law, also may need to be considered, as described below in Section III, 2 Control and its Definition. We note that the primary federal regulator for the subsidiary bank may also conduct a review of the investment under the CIBCA in such cases. 10

13 Reserve, meaning the staff of the Federal Reserve Board in Washington may be required to render the final determination. In light of the above, it is suggested that, prior to agreeing to make a significant bank investment, a pre-filing meeting be organized with documents outlining the transaction delivered to the Federal Reserve for consideration and review prior to the pre-filing meeting. Significant departures from traditional approaches in the investment documents, whereby investors may be granted additional rights or powers (including veto authority) to control or influence the management of a bank, or significant departures from expected investment structures, may give rise to a control determination or lengthen the time necessary for the regulators to reach a decision on the proposal. In any case, the process will take several weeks for regulators to reach a determination. Appropriate foresight is necessary to ensure sufficient time is available to complete the review. Among the determinations that will be made is whether a Change of Bank Control notice will be required to be filed in accordance with the provisions of the CIBCA, as more fully described in Section III, 4 Cases Where Prior Approval May Not Be Required Rebuttable Presumptions of Control and CIBCA Filings. 2. Control and its Definition Among bank regulatory agencies, the Federal Reserve has developed an authoritative and elaborate set of guidance and principles on what constitutes control, as well as consequences of such a finding. These standards are of significance for purposes of evaluating the consequences of control under two very significant statutory regimes - the BHC Act (which requires the approval and registration of a BHC in the case of a finding that an entity has acquired a controlling influence over the management and business practices of a bank or its holding company),6 and the CIBCA (which imposes certain filing obligations and related notification requirements prior to an individual s investment that constitutes a change in control of a bank). Because, in some cases, the statutory definitions in the CIBCA differ from those in the BHC Act, a regulatory agency may find a change of control to exist under the CIBCA without also finding that control exists for purposes of the BHC Act. One should also bear in mind that, if applicable, different state laws and regulatory regimes may follow different standards for what constitutes control.7 For reference purposes, we have produced a summary chart that outlines key regulatory thresholds under both the BHC Act and the CIBCA, and that summary is attached as 6 7 Note that the HOLA, as administered by the Federal Reserve following the transfer date for the Dodd-Frank Act, rather than the BHC Act, is the statutory regime under which entities with a controlling interest in savings associations are determined to be savings and loan holding companies, requiring prior Federal Reserve approval similar to BHCs. To this end, it should also be recalled that different states may have divergent standards and legislative tests for the concept of control; however, most follow the federal standards discussed above. 11

14 Appendix A Overview of Key Thresholds for Control Under the Federal Banking Laws. Often, investors and institutions focus primarily on thresholds for acquisitions of voting interest, and those thresholds are set forth in the chart below: Individuals Entities 8 5% or more voting interest None File a passivity commitment with, and obtain acceptance from, the Federal Reserve, assuming the investor does not become a BHC 10% or more voting interest File a Change in Bank Control Notice with the appropriate federal banking agency None, assuming a passivity commitment discussed above was filed at 5% or more voting interest, and the investor does not become a BHC 25% or more voting interest None File an application (FR Y-3) with the Federal Reserve to become a BHC When reviewing these thresholds, please note that federal bank regulators have broad discretion to interpret the voting interest standards indicating control, and a specific review of the facts and circumstances at issue would be required for any significant bank or parent company investment. Also, other indications of control beyond voting ownership may cause a regulator to determine that an investor is exercising a controlling influence over the management or policies of bank or its parent, and thus is in a control position. As noted, a finding of control for purposes of the BHC Act entails the conclusion that a legal entity having control over a bank will be deemed to be a BHC. The consequences of such a determination are significant for the BHC: it faces limitations on the scope of its non-financial activities and is required to serve as a source of managerial and financial strength for the depository institution it controls. Thus, such company must maintain consolidated capital levels consistent with regulatory standards for a BHC, as more fully set forth in Section IV, 3 Regulatory Issues in Structuring Investments Consequences to an Investor of a Finding of Control. Conversely, a change of control filing under the CIBCA does not rise to the level of a formal request for regulatory approval of the investment, but involves, instead, a notice filing with a finding of non-objection by the appropriate agency. Following an investment that is deemed to be a change of control for CIBCA purposes, but not an acquisition of control for BHC Act purposes, the investor is not subject to ongoing activities limitations and capital requirements.9 However, CIBCA review does call for background information on the 8 9 Entities generally include trusts (with the possible exception of certain estate planning trust vehicles), funds, corporations, partnerships, limited liability companies, limited partnerships, and other forms of legal entities, and exclude individuals. An investor that has filed for, and obtained, regulatory non-objection for a proposed investment under the CIBCA thereafter falls within the definition of an institution affiliated party for purposes 12

15 investor group and its overall business qualifications and objectives.10 Note that investments that are approved under the BHC Act are exempted from review under the CIBCA. The most recent guidance offered by the Federal Reserve on non-control investments came in the form of a Policy Statement on Equity Investments in Banks and Bank Holding Companies, issued in September In this Statement, the Federal Reserve notes the standards for determining control under the BHC Act: The BHC Act provides that a company has control over a banking organization if (i) the company directly or indirectly or acting through one or more other persons owns, controls or has power to vote 25 percent or more of any class of voting securities of the banking organization; (ii) the company controls in any manner the election of a majority of the directors or trustees of the banking organization; or (iii) the [Federal Reserve] Board determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the banking organization. Under pertinent Federal Reserve interpretations, a group of investors may be deemed to be acting in concert, and thus have their respective investments aggregated for purposes of a control determination, if the regulator finds knowing participation in a joint activity or parallel action towards a common goal of acquiring control of a state member bank or bank holding company whether or not pursuant to an express agreement. 11 A significant point made by of Section 8 of the Federal Deposit Insurance Act. As a result, the bank regulators have authority to impose orders and undertake enforcement actions against such investors for certain unsafe and unsound practices and legal or regulatory violations. 12 U.S.C. 1818(b). For example, financial data on the part of the investor making such filing will be required, as will information on the business background and personal or corporate history of the investor and on the source of the funds being used for the investment. In addition, the CIBCA notice will be the subject of publication requirements in appropriate local newspapers, and the potential source of public comment as a result. Background verifications and fingerprinting for significant investors or their principal managers will be likely. 12 C.F.R Section (b)(2). Similarly, the OTS has provided guidance on what constitutes control and what steps may be taken to rebut the presumption of its existence under the HOLA. These standards are generally consistent with the approach on control set forth in 12 C.F.R. Section 574.4, which notes as follows: An acquiror shall be determined, subject to rebuttal, to have acquired control of a savings association, if the acquiror directly or indirectly, or through one or more subsidiaries or transactions or acting in concert with one or more persons or companies, holds any combination of voting stock and revocable and/or irrevocable proxies, representing more than 25 percent of any class of voting stock of a savings association, excluding such proxies held in connection with a solicitation by, or in opposition to, a solicitation on behalf of management of the savings association, but including a solicitation in connection with an election of directors, and such 13

16 the Federal Reserve is that [c]ontemporaneous minority investments in the same banking organization by multiple different investors also often raise questions about whether the multiple investors are a group acting in concert. 3. Cases Where Prior Approval Will Be Required Irrebuttable Presumptions of Control An investor or group of investors acting in concert may, as a general matter, acquire an interest in a bank or a BHC below the thresholds discussed herein without obtaining the prior regulatory approval, unless the position in question is deemed to establish a controlling influence over the operation of the entity. Federal banking law establishes a number of parameters with respect to how much equity, and how many other management and related rights, may be acquired with respect to a bank before a controlling influence will be deemed to arise. As a general matter, the following are instances where control will be irrebuttably presumed to exist, thus mandating prior approval of the investor or group of investors: An investment that equals or exceeds 25 percent of the voting shares of the banking entity will cause the investor that is acquiring such a position (whether acting individually or in concert with other investors) to obtain the prior approval of the pertinent bank regulatory agencies. An investment that exceeds 33 percent of the total contributions to the equity of the banking entity, whether as a combination of voting or non-voting shares or through the holding of subordinated debt or other positions treated as equity for accounting or regulatory purposes, will also cause the investor acquiring such a position (whether acting individually or in concert with other investors) to obtain the prior approval of the pertinent bank regulatory agencies. For purposes of these analyses, a class of non-voting stock, debt, preferred stock or other securities that is convertible into voting stock, may be deemed to represent the class of stock into which it is convertible, irrespective of conditions or time periods for conversion. 4. Cases Where Prior Approval May Not Be Required Rebuttable Presumptions of Control and CIBCA Filings Historically, the Federal Reserve has determined that an investment which equals or exceeds 10 percent of the voting shares of a banking entity, but which is less than 25 proxies would enable the acquiror to: (i) elect one-third or more of the savings association's board of directors, including nominees or representatives of the acquiror currently serving on such board; (ii) cause the savings association's stockholders to approve the acquisition or corporate reorganization of the savings association; or (iii) exert a continuing influence on a material aspect of the business operations of the savings association. 14

17 percent of the voting shares and less than 33 percent of the total contributions to equity, creates a rebuttable presumption of control. More recently, however, the Federal Reserve has found that, in the case of certain investors that possess unique characteristics or raise special concerns from a regulatory perspective, a lower threshold of investments that equal or exceed 5 percent of the voting shares of the entity will result in a presumption of control. Such investors generally include private equity investors or funds, in light of perceived investment objectives, strategies for shareholder influence and involvement in the business of the bank. The lower threshold for review in these cases is designed, in part, to allow the regulators to collect information on such investors, and to allow for monitoring of the investors activities, timing of investments and divestitures and common investment decisions among multiple parties, particularly in light of potential acting in concert considerations. Accordingly, it will be important for an investor that falls into this category, along with the banking entity that is the subject of the investment, to arrange for a pre-filing meeting with regulators to review the details of the anticipated investment structure before making the investment. Although such reviews are very fact-driven, the following general considerations may be helpful in analyzing whether the presumption of control may be rebuttable in the view of the regulators: A Sliding Scale of Voting Interests. Lesser percentages of voting interests generally trigger a lesser likelihood for regulatory focus, as compared to larger voting positions. For example, an investor with a 24.9 percent voting position may find itself more likely to be deemed to control the bank than an investor with a 14.9 percent voting interest and similar ownership rights and rights and privileges. Bank Interactions Outside of the Proposed Investment. Significant relationships or historic interaction between the investor and the bank may elevate the regulators concern that an investor within the range of a rebuttable presumption of control does, in fact, control the bank. For example, an investor that also has a long-standing, major credit relationship with the bank, that intends to acquire loans or real estate assets from the bank or that is a major service provider to the bank is more likely to be deemed to control the bank than an investor that has no relationships with the bank other than its equity investment. Passivity Commitments. Rebutting a presumption of control will be predicated upon an investor entering into certain fairly standard passivity commitments, which are structured to avoid a characterization of control, and to refute an indication that such investor may be acting in concert with other shareholders. These undertakings are described in detail in Section IV, 2 Regulatory Issues in Structuring Investments Rebutting Control / Passivity Commitments. In addition to mitigating potential control factors, the passivity undertakings are designed to minimize the effect of any prior relationships that may have existed between any investor and any members of current or proposed management of the bank. These commitments include direct limitations on the investor in exercising a controlling influence over the management 15

18 of the bank (including prohibitions on naming any management official or setting corporate business policies or compensation). With respect to potential acting in concert concerns, the commitments also impose constraints on agreements or voting arrangements with other investors, including by voting for a common slate of directors, acting upon the advice of a common investment advisor, or engaging in other banking ventures or investments with the same investors. In cases where prior or current relationships may exist among non-controlling investors and a proposed member of the management group, by virtue of consulting, employment, or investment arrangements, the regulators will likely require all such ties be severed so as to avoid any indirect exercise of influence by the investor. Any financial or other agreements (including salary, insurance or equity ownership arrangements involving the proposed investor and the executive) must be terminated. In some instances, the investor may be required to agree not to re-hire or re-engage any such executive for a period of two years after he or she leaves the management team of the bank. Board Representation. A non-control investor may nominate one director to the board of the bank and one director to the board of the BHC, provided that the director representation does not exceed a proportionate percentage of the investor s ownership interest and does not exceed, in all events, 25 percent of the voting members of the board or of any specific committee of the board of directors. An investor-nominated director will also be precluded from participation on a committee that has decision making authority on managerial matters for the bank. In the case of club investment structures involving a small number of significant private investment fund investors each such investor may be able to nominate a separate board member, provided that the majority of the members of the board remain independent. Under certain limited and unique circumstances, an investor that meets the criteria set forth above may be able to nominate a second director, provided the bank is controlled by a larger, unaffiliated shareholder registered as a BHC, and the number of director nominees does not exceed 25 percent of the voting members of the board and is proportionate to the investor s stake in the bank. In addition, it may be possible, in certain cases, to designate a non-voting observer to attend directors meetings, although this option is carefully reviewed by most regulatory agencies to assure that the observer does not provide any investors with impermissible influence over the board.12 The Largest Shareholder Factor. Indicia of control by an investor are lessened if an unaffiliated shareholder has a larger position in the entity. The mitigating role of a larger, unaffiliated shareholder is further strengthened from a regulatory perspective when the larger shareholder is in a regulated control position as a BHC. 12 It should be noted that both the director, as well as the individual or company investor that nominates the director, will be subject to background checks and informational reviews. 16