Private Equity and Hedge Fund Investments in Bank Holding Companies: Finding a Safe Harbor in the Federal Reserve’s Regulatory Maze

by admin on September 8, 2011

Guest post by Xingjian Zhao,
Diaz Reus & Targ, LLP

Bank Holding Company Act and Change in Bank Control Act are two laws that affect investment in bank holding companies.

The credit crisis that gripped U.S. and global financial markets, and the ensuing economic meltdown, have created fresh investment opportunities for private equity and hedge funds. Two main factors have historically discouraged private equity investment in banking institutions. First, significant investments in banking institutions can invite some unwelcome regulatory burdens that private equity and hedge funds are specially structured to avoid. Second, the high costs of investing in bank holding companies often do not justify the risks and expected returns. However, recently announced changes in regulatory policy and significant declines in banks’ stock prices have created a more attractive environment for private equity and hedge funds to invest in banking institutions. Investments in failed banks will continue to be limited by strict Federal Deposit Insurance Corporation (FDIC) guidelines, which have been relaxed somewhat to attract more private equity investments in at-risk banking institutions.

The Federal Reserve Encourages Private Equity Investment in Bank Holding Companies

On June 29, 2011, the First NBC Bank Holding Company raised approximately $27 million through a private placement of 523,863 shares of common stock and 1,680,219 shares of Series C preferred stock at a price of $12.25 per share.1 The shares were purchased by Castle Creek Capital Partners IV, L.P., managed by its general partner Castle Creek Capital IV, LLC, which is a private equity fund headquartered in Rancho Santa Fe, California.2

The BHCA’s 25 percent ownership threshold, however, remains a bright-line test for control of a bank and the existence of bank holding company status.

Banking institutions and bank holding companies such as First NBC have been forced to actively seek capital from all available sources to replenish liquidity lost during the most recent financial crisis. Cue in private investment funds like Castle Creek Capital IV, LLC. With the stock value of many financial firms at bargain basement prices, opportunities now exist for private investment funds to capture low-cost equity stakes in publicly labeled “well-built” financial institutions. However, private equity funds investing in bank holding companies must take heed of the regulatory hurdles created by the Bank Holding Company Act (BHCA).3 These investors must also pay attention to provisions of the Change in Bank Control Act (CIBCA),4 as well as specific regulations of the Board of Governors of the Federal Reserve System (FRB).

The BHCA imposes significant regulation and oversight by FRB upon companies that control banks. Companies that control banks are considered bank holding companies and are subject to minimum capitalization requirements, limitations on non-banking
activities, restrictions on transactions with affiliate entities, and other regulatory burdens. For regulatory purposes, a company “controls” an entity if it

  • (a) directly or indirectly owns or holds the power to vote 25 percent or more of any class of the entity’s
    voting stock;
  • (b) has the ability to appoint a majority of the entity’s directors; or
  • (c) has the ability to exercise a “controlling influence” over the entity’s management or internal policies.5 Under the BHCA, FRB has significant discretion in determining what constitutes a “controlling influence” over a banking institution.

In a nutshell, private equity funds may not “control” the banks in which they invest, unless they are bank holding companies, or are willing to become bank holding companies and be regulated by the BHCA. Should a private equity fund “control” or “exercise
a controlling influence” over a bank or bank holding company, it is regulated by FRB on an ongoing basis as a bank holding company. Such regulation requires the private equity firm to limit its activities to those “related” to banking, and refrain from engaging in “non-banking” activities that undermine a bank’s capitalization and financial soundness.

To attract greater private equity investment in banks, FRB has relaxed many of its discretionary policy guidelines that determine what ownership thresholds, board representation levels, and conduct of a bank’s management constitute a “controlling interest” as defined by the BHCA.6 These recently revised FRB policies generally encourage minority investment by hedge funds and private equity firms. Under these guidelines, a minority shareholder may own up to 33 percent of a bank’s or bank holding
company’s total equity before FRB presumes the presence of a “controlling interest,” so long as the investor does not own or control the power to vote on more than 15 percent of any class of voting securities.7 The BHCA’s 25 percent ownership threshold, however, remains a bright-line test for control of a bank and the existence of bank holding company status.

Moreover, a minority shareholder can now enter into business relationships or transactions with a bank or bank holding company on a case-by-case basis, based on the size of the proposed relationship or transaction, whether the relationship is on market terms, whether it is non-exclusive, and whether it may be terminated without penalty.8 Private equity minority shareholders may also communicate and consult with the board of the banking institution to influence the corporate policies of the bank or bank holding company in the same manner as any other shareholder.9 Such shareholders may also have at least one seat on the bank’s board of directors.10 Additionally, a minority shareholder may hold two seats on the bank’s board of directors if three conditions are met: (1) its board representation is proportionate to its ownership interest, (2) it holds fewer than 25 percent of voting seats on the board, and (3) another shareholder (that is a bank holding company) controls the bank.11 Finally, a private equity minority shareholder can now enter into a shareholders’ agreement that contains covenants prohibiting the issuance of senior securities or borrowings, consultations rights, and information rights.12 More extensive covenants, such as limitations on hiring practices, raising additional capital, or engaging in new business, may still be deemed to be indicative of a “controlling interest” under the BHCA.

“Control” Analysis Entails Review of Multiple Factors

Questions surrounding “control” of a bank or bank holding company for BHCA purposes remain multifaceted. The organizational regime, ownership structure, management practices, and identity of principal investors in the private equity fund all play an integral part in FRB’s determination of the threshold of “control.” Furthermore, FRB may include the amount of the bank holding company’s securities that will be purchased by the private equity fund in its “control” analysis.

Although a company may usually acquire up to 24.9 percent of a bank holding company’s stock before triggering bank holding company status under the BHCA, FRB often takes into consideration other indicia of control. For example, FRB may review the number of directors that will stem from a proposed transaction and the private equity fund’s inclusion in board activities. A private equity fund may not have its members act as participating officers or board committee chairs of a bank or bank holding company. Moreover, FRB will assess the amount of influence the private equity fund will have on the management or policies of the institution. The FRB’s most recent policies will likely benefit private equity firms and hedge funds desiring to acquire stakes in banks or bank holding companies. Additionally, the new policy will help inject some much-needed capital into the banking sector.

With respect to a public company, presumption of control under the CIBCA is triggered by director indirect ownership of 10
percent or more of the institution’s outstanding common stock.

In addition to the BHCA’s requirements, the CIBCA13 should also be considered. With respect to a public company, presumption of control under the CIBCA is triggered by direct or indirect ownership of 10 percent or more of the institution’s outstanding
common stock.14 If a transaction becomes subject to the CIBCA, the private equity investor must submit a notice to FRB and the bank’s primary federal regulator (if different than FRB) that includes not only extensive information about the private equity entity, but also detailed biographical and financial information from the individuals who control the private equity investor. Some private equity companies are unwilling to file a CIBCA notice because of its intrusive nature, and because, after approval, they
will become an “institution-affiliated party”15 under Section 3(u) of the Federal Deposit Insurance Act, and therefore will be subject to the same set of potential regulatory liabilities as bank directors and officers. Other private equity investors are willing to file a CIBCA notice because, unlike the BHCA, the CIBCA does not impose any limitations on the investor’s other activities or require the investor to serve as a source of liquidity to the bank. Often, a CIBCA-triggering transaction is also necessary for the investors to inject a sufficient dollar amount in the target financial institution.


The recent financial crisis has created fresh and lucrative investment opportunities for private equity and hedge funds. However, these funds must approach investments in these banking institutions, or their holding companies, with the “control” thresholds in mind. The restrictions on the exercise of “control” reinforce the importance of the specific private equity or hedge fund being comfortable with the holding company or banking institution at the beginning of the parties’ relationship. At the inception of the relationship, the fund will have the greatest ability to influence the manner in which the holding company or banking institution operates. Being privy to the risks, regulatory standards, and complexities involved with each investment in a bank holding
company will permit the private equity or hedge fund to reap the rewards of its investment.

Robert Q. Lee is a partner in the transactional practice group of Diaz Reus & Targ, LLP, where he concentrates his practice on corporate and banking, securities, secured transactions, commercial real estate, and international business law (particularly in Asia).

Sumeet H. Chugani is an associate with the firm, where he focuses his practice on cross-border transactions, international dispute resolution, and regulatory compliance and support.

Xingjian Zhao is an associate attorney with the firm’s Shanghai office, where he focuses his practice on complex commercial litigation, appellate litigation, regulatory compliance, cross-border transactions, and Chinese law.

1 Castle Creek Capital, Press Release, First NBC Bank Holding Company
Completes $27.0 Million Private Placement of Common Stock and Preferred
Stock (July 7, 2011).
2 Id.
3 12 U.S.C. § 1841, et seq.
4 12 U.S.C. § 1817(j).
5 12 U.S.C. § 1841(a)(2).
6 See FRB, Policy Statement on Equity Investments in Banks and Bank Holding
Companies (Sept. 22, 2008).
7 Id. at 10.
8 Id. at 12-13.
9 Id. at 11-12.
10 Id. at 6.
11 Id. at 7.
12 Id. at 13-14.
13 See supra at note 4.
14 E.g., 12 C.F.R. § 225.41(c)(2).
15 12 U.S.C. § 1813(u).

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