Yesterday, Treasury issued a public term sheet setting forth the terms on which eligible financial institutions that have made a valid election to be taxed under Subchapter S of the Internal Revenue Code ("S corporations") may participate in the Capital Purchase Program (CPP). The deadline for S corporations to apply for CPP funding is February 13, 2009.
Initially, the most notable difference from the CPP term sheets for publicly traded and non-exchange traded eligible institutions is that Treasury will purchase subordinated debt from an eligible S corporation, rather than preferred stock. Among other restrictions applicable to S corporations, an S corporation may have only one class of equity and that equity generally can be held only by natural persons. Because Treasury cannot hold preferred or common stock of an S corporation, it has developed "an economically equivalent security that meets certain regulatory capital requirements and is sensitive to the restrictions applicable to S-Corps."
Key components of the S corporation CPP term sheet and any material differences from the publicly traded and non-exchange traded term sheets include the following:
- Qualifying financial institutions (QFIs) – generally include any S corporation that is also a U.S. bank, savings association, top-tier bank holding company, or top-tier savings and loan holding company that is not controlled by a foreign bank or company.
- Participation – S corporation QFIs must elect to participate before 5:00 p.m. EDT on February 13, 2009, and enrollment is through the organization’s primary federal regulator, rather than through the Treasury.
- Subscription Amount – Minimum subscription is 1% of risk-weighted assets; maximum subscription is 3% of risk-weighted assets (or $25 billion, whichever is less).
- Security Purchased – Treasury is purchasing non-voting (except on class-specific matters) 30 year subordinated debentures, each note representing a principal amount of $1,000, paying interest at 7.7% per annum until the 5th anniversary of investment and at a rate of 13.8% per annum thereafter ("Senior Securities"). The interest rates for the Senior Securities are higher than the dividend rates of the preferred stock obligations of other QFIs because the interest paid on the Senior Securities is tax deductible while the dividend payment on the preferred stock investments is not, and therefore the rate difference "equalizes the effect on all taxpayers." The Senior Securities will not constitute a second class of stock, however they will rank senior to a QFI's common stock (and any other class of equity, as applicable, such as if the QFI converted to a C corporation). Unlike the publicly traded and non-exchange traded term sheets which provide all eligible institutions issuances with Tier 1 capital regulatory status, the Senior Securities will be classified as Tier 1 capital for a holding company and Tier 2 capital for a bank or savings association.
- Voting Rights - The Senior Securities will be non-voting, except on class-specific matters (including the right to elect two directors if interest is unpaid for six interest periods, whether or not consecutive, such right to end upon full payment of all prior unpaid interest).
- Dividend and Repurchase Restrictions - Like the terms attributable to the preferred stock issues, an S corporation QFI is prohibited from increasing any regularly paid common dividends for the first three years from the date of investment without Treasury consent. Similar to a non-exchange traded QFI (where dividend increases are limited to 3% per annum without Treasury approval), from year four through year ten, Treasury approval is required for an S corporation QFI to increase aggregate common dividends greater then 103% of the prior year's dividend rate, unless Treasury's investment has been redeemed in whole or Treasury has transferred its investment to unaffiliated parties (note that for a non-exchange traded QFI, the transfer may be to any third party). A publicly-traded QFI has no dividend increase restrictions after the third anniversary. Notwithstanding the foregoing, Treasury approval will not be required for any increase in dividends where such increase is solely proportionate to the increase in taxable income of the S corporation QFI and such increased dividends are distributed to shareholders in order to fund their individual tax payments on such allocable taxable income. With respect to repurchase restrictions and similar to a non-exchange traded QFI, Treasury approval is required to repurchase equity securities or trust preferred securities until the 10th anniversary of the investment unless Treasury's investment is redeemed in whole or Treasury has transferred its investment to a third partie(s), and from and after year 10, a S corporation QFI cannot repurchase any equity securities or trust preferred securities or pay common dividends until the Treasury investment is redeemed in whole (note a slight difference in that a non-exchange traded QFI, from and after year 10, may repurchase equity or trust preferred securities or pay common dividends upon Treasury's transfer of such securities to third parties). A publicly-traded QFI has no repurchase restrictions after the third anniversary.
- Transfer of Shares – Treasury may transfer the Senior Securities to any third party at any time, provided that, Treasury will use commercially reasonable efforts not to effect any transfer that would require the S corporation QFI to become subject to any periodic public reporting requirements pursuant to the Exchange Act. If the QFI otherwise becomes subject to such public reporting requirements, the S corporation QFI will file a shelf registration statement and Treasury and its transferees will receive registration rights to facilitate any transfers.
- Redemption – Senior Securities are callable at par any time after three years. Senior Securities may be redeemed during the first three years only with the cash proceeds of a qualifying offering (such gross proceeds equal to 25% or more of the issue price of the Senior Securities) of Tier 1 capital in the case of a holding company, and Tier 1 or 2 capital in the case of a bank or savings association.
- Warrants – To comply with EESA requirements that Treasury obtain warrants or other contingent consideration when purchasing troubled assets, Treasury will receive warrants with an exercise price of $0.01 to purchase additional Senior Securities ("Warrant Securities") in an amount equal to 5% of the initial Senior Securities investment. The warrants will have a 10-year term (with the Warrant Securities themselves having a maturity of 30 years), however Treasury intends to immediately exercise the warrants. The warrants shall have the same rights, preferences, privileges and voting rights and other terms as the Senior Securities, except the Warrant Securities will pay interest at 13.8% per annum and may not be redeemed until all Senior Securities have been redeemed. The warrants provided to Treasury by an S-Corporation QFI is similar to the warrant for the non-exchange traded QFI, however vastly different than the publicly-traded QFI as described in the following.
- Executive Compensation Limitations – Also consistent with EESA requirements, so long as Treasury is a debt holder, the S corporation QFI must comply with Treasury’s announced executive compensation and corporate governance requirements, including amending existing employment agreements and benefit arrangements to comply with those requirements.
- Affiliate Transactions - S corporation QFIs will be subjected to limitations on related-party transactions akin to those typically applicable to public companies in that, so long as Treasury holds any debt securities of the S corporation QFI, the QFI and its subsidiaries will not enter into any transactions with related persons (within the meaning of Item 404 under the SEC’s Regulation S-K) unless (i) such transactions are on terms no less favorable to the QFI and its subsidiaries than could be obtained from an unaffiliated third party, and (ii) have been approved by the audit committee or comparable body of independent directors, or if there are no "independent directors," the board of directors of the QFI.
According to Treasury FAQs, S corporation QFI definitive agreements will be available within a few weeks, and that applicants should refer to the terms of the existing agreements for publicly-traded and non-exchange traded C corporations for guidance on terms that will form the basis for S corporation QFI definitive agreements.
The S corporation term sheet does not apply to mutual companies which themselves are not able to issue stock. Treasury has stated that it is continuing to work with the federal banking agencies on a solution for mutual companies.