Teaming Up on FDIC-Assisted Deals

Resolution Asset Management Co. L.P. was formed in 2010 to assist healthy banks acquire failed institutions from the Federal Deposit Insurance Corp. with loss-sharing agreements where the agency provides some measure of protection against losses. A subsidiary of Cantor Fitzgerald, RAM will provide capital to support the transaction, and has a dedicated team of professionals with real estate, asset management, banking and regulatory experience that can help banks bid for failed institutions and manage the acquired assets. Recently, Bank Director talked with Managing Director Rodney A. Montag about the outlook for FDIC-assisted deals, and how the RAM structure works.

What’s the outlook for FDIC assisted deals in 2011?

The outlook is pretty good, or bad, depending how you view it. We’ve had 322 failures since the current crisis began and we are projecting an additional 300 plus failures over the next few years. Looking forward, one of the big differences will be the average size of the bank failures, which we believe will get smaller.

Has the failure rate of banks peaked or do you think the situation will continue to worsen given the industry’s on-going asset quality problems?

I think that’s more of a regulatory policy question than anything else. There is a backlog of troubled banks to deal with and they’re only closing the worst of the worst, which is to say the banks that have diminished liquidity. They seem to be focused on banks with serious liquidity issues as opposed to those banks with operational or other asset problems.

What are the greatest challenges in doing an FDIC assisted deal?

The first is the availability of capital. Even if a healthy bank has sufficient capital, most banks are in a capital preservation mode and don’t want to spend it, including for an acquisition. The second challenge is working out the good and bad assets that are acquired from the failed institution. The third is the bidding process, which is competitive whether in or outside of your marketplace.

How does Resolution Asset Management work with a participating bank?

The bank will form an operating subsidiary of which RAM will be a non-voting minority member. The bank itself will acquire the failed bank’s deposits and liabilities, while the assets of the failed bank that are covered by loss share will be transferred to the operating subsidiary at a value agreed upon by RAM and the bank. A RAM affiliate will use its real estate, valuation and asset management expertise to manage these covered assets. RAM will provide to the operating subsidiary capital necessary to support the acquisition, which is usually a non-dilutive way for the bank to raise capital. The bank will hold a preferred equity ownership position in the op-sub and all of the voting portion of the common equity. In other words, RAM is a passive investor in the operating subsidiary with no interest in the bank or holding company.

What is your exit strategy once the bank’s loss-share agreement with the FDIC has been concluded?

Our equity interest is solely in the operating subsidiary; once all the covered assets have been resolved either through liquidation or modification, the subsidiary itself will be liquidated and RAM will no longer have any equity interest. And of course we never had any ownership interest in the bank parent or the bank holding company, which is a big difference between our structure and a private equity investment in the bank.

Are there steps that a bank should be taking even before they contact RAM?

It’s important to understand that a bank has to have our structure in place before they can bid on a failed bank, though we can also participate with a bank on a transaction they have already closed upon. We spend as much time underwriting the participating bank to confirm its health for our structure as we do reviewing the failed bank. The participating bank also has to submit our structure to its primary regulator for approval, which takes added time.

What Keeps Directors Up at Night

worried.jpgDuring the S&L crisis of the late 80’s and early 90’s, the Federal Deposit Insurance Corporation sued or settled claims against bank officers and/or directors on nearly a quarter of the institutions that failed during that time. If the past is any indication of the future, then there is a significant risk that directors of failed banks from the recent financial crisis may see some type of action taken against them by the FDIC.

In addition to lawsuits against senior executives of IndyMac Bank, and also senior officers and directors of Heritage Community Bank in Illinois, the FDIC has authorized actions against more than 109* insiders at failed banks to recover over $2.5* billion in losses to the deposit insurance fund resulting from this wave of bank failures.

Based on their work with a number of banks as well as individuals who are the targets of recent FDIC cases in various stages of development, John Geiringer and Scott Porterfield from the Chicago-based law firm of Barack Ferrazzano answer some questions about what could be keeping bank directors up at night.

What are the steps taken by the FDIC after the closure of a bank?

The FDIC begins a preliminary investigation when it believes that a bank may fail and will interview bank employees, officers and directors promptly after the bank’s closure.It is common for the FDIC to send a demand letter to the bank’s officers and directors demanding payment, usually in the tens or hundreds of millions of dollars, shortly before the expiration date of the bank’s D&O insurance policy.The FDIC sends that letter in an apparent attempt to preserve the D&O insurance for any litigation claims that it may later assert.

The FDIC may then subpoena officers and directors for documents and depositions. After conducting depositions, the FDIC will decide whether to initiate litigation against any officer or director. If the agency decides to litigate, it will initiate settlement discussions before actually filing its lawsuit. Because of the many evolving issues in these situations, such as whether insiders may copy documents for defense purposes before their banks fail, potential targets of these actions should ensure that they are being advised by counsel through every step of this process, even before their banks have failed.

What are the legal standards by which the FDIC may sue directors?

The FDIC bases its lawsuits on general legal principles that govern director and officer conduct and also considers the cost effectiveness of any potential lawsuit when making its decision. Federal law allows the FDIC to sue directors and officers for gross negligence and even simple negligence in certain states. What those standards mean as they relate to the conduct of bank insiders during this unprecedented economic cycle is difficult to predict at this time, although we are getting a clearer picture.

In the Heritage case, for example, the FDIC alleges that the defendants did not sufficiently mitigate the risks in the Bank’s commercial real estate portfolio and made inappropriate decisions regarding dividend and incentive compensation payments.

Will the FDIC differentiate between inside and outside directors?

Whether someone is an inside or outside director is one of the factors that the FDIC considers in determining whether to sue a director of a failed bank. According to the FDIC’s Statement Concerning the Responsibilities of Bank Directors and Officers, the most common lawsuits likely to be brought against outside directors will probably involve insider abuse or situations in which directors failed to respond to warnings from regulators and bank advisors relating to significant problems that required corrective actions.

Will D&O insurance cover any liability to the FDIC?

That depends on the amount and terms of the D&O policy. Directors should work with their insurance broker and bank counsel to review their D&O policies and to help them to make this determination. They should determine whether their policy amount is sufficient, whether their policy has certain exclusions (such as regulatory and insured vs. insured exclusions), whether proper notices are being made and under what conditions their policy can be cancelled.

What can directors do to mitigate their risk in the event that their bank fails?

In its Policy Statement, the FDIC states that it will not bring civil suits against directors and officers who fulfill their responsibilities, including the duties of loyalty and care, and who make reasonable and fully informed business judgments after proper deliberation. The FDIC generally requires bank directors to: (i) maintain independence; (ii) keep informed; (iii) hire and supervise qualified management; and (iv) avoid preferential transactions.

Directors should ensure that their bank’s counsel and other advisors are discussing these crucial issues with them. If their bank is in troubled condition, directors should seriously consider the need to hire personal legal counsel and to understand their ability to obtain indemnification.

Figures updated as of 1/4/11 based on latest reportings.

Opportunity is Knocking in Bank M&A

If there was one compelling theme at Bank Director’s “FDIC-Assisted Bank Deals: Opportunity Knocks” one-day seminar, which took place on Oct. 22 at the Four Seasons Hotel in Las Vegas, it’s that acquiring a failed bank from the Federal Deposit Insurance Corp. is one of the best growth options available to banks and thrifts today.
Although the actual structure may vary from one transaction to another, the typical FDIC-assisted deal involves a loss sharing arrangement where the agency agrees to reimburse up to 80% of losses incurred by the acquirer on “covered assets” up to a certain amount. The bank acquirer would be responsible for 20% of the losses up to the agreed upon ceiling – and 100% of the losses thereafter.

Non-Traditional Growth Opportunity

While FDIC-assisted deals offer tremendous opportunities for growth in a banking market where traditional M&A volume is at historically low levels, and where organic growth has been limited by a lackluster economy, they are a demanding and extremely complex undertaking. Interested banks are not told how many competitors are bidding for the failed institution, due diligence is limited and all deals are final – which places tremendous pressure on participants not only to submit competitive bids, but also to avoid missing something that could have serious financial ramifications later on. These are high stakes deals that place considerable pressure on the bidding institutions and their financial and legal advisors.

Not just any bank or thrift can bid on a failed bank, either. Qualified bidders must have at least a CAMEL I or II rating for capital adequacy and management. (So-called CAMEL ratings are used by federal banking regulators to assess the condition of a financial institution, with I being the highest.) And according to experts at the seminar, it also helps if the bidder has a proven track record at acquiring and integrating banks.

Future of Bank Earnings

John Duffy, CEO of investment bank Keefe Bruyette & Woods Inc. in New York, kicked off the seminar with an extensive overview of the banking industry. According to Duffy, the industry’s profitability (defined as earnings prior to taxes and loss reserve provisions) bottomed out in the second quarter of 2009, but any growth since then has been modest at best. One important bright spot is that the three-year rise in non-performing assets finally peaked in the second quarter of this year, which holds out hope that a somewhat stronger rebound in bank earnings may be in the offing.

Jeff Brand, a KBW principal who has worked on several FDIC deals in the past year, pointed out that as of Oct. 22 there were 829 banks on the FDIC’s trouble bank list. And with the agency expected to spend an estimated $60 billion over the next four years to clean up after failed banks, the market for FDIC-assisted deals should remain strong for the foreseeable future.
The regions of the country with the most failures (and therefore the greatest opportunities), according to Brand, are the Southeast, upper Midwest and West.

Tips on Making a Bid

Jim McAlpin Jr., a partner at the law firm Bryan Cave in Atlanta, advised the directors in attendance to contact the senior FDIC officials in their region even before making a bid on a failed bank. Although the FDIC is required by law to seek the lowest cost resolution when a failed bank has been placed under its control through receivership, it’s still beneficial for the agency to have had personal contact with the management team at an institution prior to the submission of a bid.

Surprisingly, McAlpin also advised that prospective bidders should attempt to talk with trouble banks in their region before they fail and are placed in receivership. The FDIC’s own watch list, as well as other easily obtained analyses that are based on public data, can help identify troubled banks that are in danger of failing. Because FDIC restrictions make it next to impossible to perform a thorough due diligence prior to submitting a bid, any insight that the bidder can glean by talking to the management team of the troubled bank beforehand can prove to be invaluable.

The bidding process is quite complex, and Rick Bennett, managing partner and leader of the bank integration practice at the New York-based consulting firm PricewaterhouseCoopers, said that bidders will need to build a sophisticated data model that will enable them to consider a variety of economic and deal structure scenarios when developing their bid. And because all FDIC-assisted deals are final, it’s crucial that potential acquirers base their bids on solid analytics.

As the old saying goes, caveat emptor!