On Oct. 14, 2008 the Secretary of the Treasury announced a voluntary program within the Troubled Asset Relief Program (“TARP”), for a direct injection of capital from the U.S. Treasury Department (“Treasury”) in the form of cumulative senior perpetual preferred stock into eligible banks, thrifts and their parent holding companies (hereinafter “banking organizations”) (pursuant to authority under Section 101 of The Emergency Economic Stabilization Act of 2008 (“EESA”)). Those banking organizations interested in participating in the Capital Purchase Program (“Program”) must be established and operating in the United States, and may not be controlled by a foreign bank or company. Applications for the Program must be submitted to the primary federal banking agency supervisor before 5 p.m. on Nov. 14, 2008. (Click here to view the TARP Application Guidelines, and here for Process-Related FAQs related to the Capital Purchase Program.)

On Oct. 20, Treasury, in conjunction with the four Federal Banking Agencies, i.e., Federal Reserve Board (“FRB”), Office of the Comptroller of the Currency (“OCC”), Federal Deposit Insurance Corporation (“FDIC”) and Office of Thrift Supervision (“OTS”), announced application guidelines for the Program.

The purpose of the Program is to provide capital to eligible banking organizations in order to increase their capital, and to promote stability in the financial markets and the banking industry as a whole. Also, to loosen the tight credit markets so that banking organizations will start lending more willingly to individuals and businesses, and to encourage the same organizations to have confidence in the interbank lending markets.

Under the Program, Treasury will provide capital (up to an aggregate of $250 billion) to eligible banking organizations by purchasing newly issued cumulative Senior Perpetual Preferred Stock (“Preferred Stock”) in the issuer banking organization. To date, $125 billion has been consigned to nine of the largest U.S. banking organizations (BofA, JPMorgan Chase, Citigroup, Merrill Lynch, Morgan Stanley, Wells Fargo, Goldman Sachs, BNY Mellon and State Street). The balance of $125 billion will be spread throughout the rest of the industry.

General Terms

  • The Preferred Stock will be senior to the issuer’s common stock and pari passu with existing preferred shares (other than preferred shares that by their terms rank junior to any existing preferred shares). The Preferred Stock will provide for cumulative dividends.
  • All of the capital purchases will occur at the highest-tier holding company. 
  • In the case of an insured depository that is not controlled by a company, the Treasury will purchase non-cumulative perpetual preferred stock of the insured depository. These shares must be pari passu with Applicant’s other most senior preferred shares.* 
  • The aggregate amount of Preferred Stock that may be issued by a banking organization to Treasury must be (i) not less than 1 percent of the organization’s risk-weighted assets, and (ii) not more than the lesser of (A) $25 billion and (B) 3 percent of its risk-weighted assets. 
  • Treasury expects the issuance and purchase of the Preferred Stock to be completed no later than Dec. 31, 2008.

What Is the Dividend Policy and What are the Redemption Rights?

  • The Preferred Stock will have an initial dividend rate of 5 percent per annum, which will increase to 9 percent five years after issuance, payable quarterly. The shares will be callable by the banking organization at par after three years from issuance, and may be called at an earlier date if the stock will be redeemed with cash proceeds from the banking organization’s issuance of common stock or perpetual preferred stock (i) that qualifies as Tier 1 capital and (ii) the proceeds of which are no less than 25 percent of the aggregate issue price of the Preferred Stock.
  • In all cases, redemption of the Preferred Stock will be subject to approval by the appropriate federal bank regulator. Following redemption of all the Preferred Stock, a banking organization shall have the right to repurchase any other equity security of the organization (such as warrants or equity securities acquired through the exercise of such warrants) held by Treasury. 
  • Dividends may continue to be paid on outstanding common and preferred shares so long as all accrued and unpaid dividends for all past dividend periods on the Preferred Stock are fully paid. Consent by Treasury will be required for any increase in the dividend on common stock for the first three years, unless the Preferred Stock has been redeemed in full, or Treasury has transferred the Preferred Stock to a third party. 
  • Treasury consent is required for share repurchases for the first three years. An exception is made in the case of share repurchases in connection with any benefit plan in the ordinary course of business consistent with the banking organization’s past practice.

What are the Voting Rights of the Preferred Stock?

  • The Preferred Stock is non-voting except for class voting rights on matters that might adversely affect the status of these shares, such as issuing senior ranking shares, amendments to the right of the Preferred Stock, or any merger, exchange or similar transaction. 
  • If dividends are not paid in full for six dividend periods, whether or not consecutive, the Preferred Stock will have the right to elect two directors. The right to elect directors will end when dividends have been paid in full for four consecutive dividend periods.

What is the Nature of the Warrants?

  • At the same time Treasury purchases the Preferred Stock, it concurrently receives 10-year warrants that are immediately exercisable, in whole or in part, to purchase common stock in the banking organization with an aggregate market price equal to 15 percent of its investment. The warrant’s exercise price and the price for determining the number of shares of common stock subject to the warrants is the market price of the common stock on the date of Treasury’s investment, calculated on a 20-trading-day trailing average. 
  • The exercise price is reduced by 15 percent on each six-month anniversary if the consent of the banking organization is not given, subject to a maximum reduction of 45 percent. 
  • The warrants are freely transferable, but only one-half of them before the earlier of (i) the date on which the banking organization has received aggregate gross proceeds from one or more qualified equity offerings totaling at least 100 percent of the issue price of the Preferred Stock, or (ii) Dec. 31, 2009. 
  • The banking organization will promptly file a shelf registration covering the warrants and the underlying common stock, and take whatever steps are necessary to have the shelf registration declared effective as soon as possible after Treasury’s investment. 
  • Treasury must be granted piggyback registration rights for the warrants and the underlying common stock, and the banking organization needs to take the necessary steps (including listing on the same exchange on which its common shares are traded) to facilitate the transfer of the warrants and the underlying common stock. 
  • If the banking organization, before Dec. 31, 2009, receives from qualifying equity offerings gross proceeds of at least 100 percent of the issue price of the Preferred Stock, the number of shares of common stock underlying the warrants shall be reduced by 50 percent. 
  • The banking organization must make certain it has enough available authorized shares of common stock to reserve for coverage in the event the warrants are exercised. 
  • If the banking organization is no longer listed or traded on a national securities exchange, or necessary shareholder consent is not received within 18 months after the warrants’ issuance date, Treasury has certain rights. The warrants can be exchanged, at Treasury’s option, for senior term debt or another economic instrument or security so that Treasury is appropriately compensated for the value of the warrant, as determined by Treasury.
  • Treasury agrees not to exercise any voting power with respect to the common stock it may acquire upon exercise of the warrants.

How Extensive are the Executive Compensation Limits?

A banking organization that participates in the Program must meet “appropriate standards for executive compensation and corporate governance” as outlined in Section 111 of EESA, for as long as Treasury holds an equity or debt position in the financial organization. These appropriate standards include:

  • Limits on incentive compensation arrangements that would encourage senior executives to take “unnecessary and excessive risks that threaten the value of the financial institution.” Within 90 days of the closing of Treasury’s investment, the compensation committee of the participating banking organization must undertake a review of its senior executive officer’s compensation arrangements with the senior risk officers to ensure that the compensation arrangements do not encourage executive officers to take excessive risks. The compensation committee must also undertake such a review on an annual basis and certify in the proxy statement that it has completed the required reviews. 
  • A provision for the recovery (often referred to as the “clawback”) of any bonus or incentive compensation paid to a senior executive officer as a result of financial reports that are later proved to be “materially inaccurate.” 
  • A prohibition on golden parachute payments to senior executive officers during the time that Treasury holds the equity or debt position. Under the Program, a golden parachute payment is only prohibited to the extent the aggregate present value of the payments equals or exceeds three times the executive’s “base amount,” as defined in Section 280G of the Internal Revenue Code, as amended by EESA. An applicable severance from employment is any severance from employment with the financial institution (i) by reason of involuntary termination of employment with the financial institution or (ii) in connection with any bankruptcy filing, insolvency or receivership of the financial institution. 
  • The $1 million limit on the deductibility of compensation paid to certain executive officers provided by Section 162(m) of the Internal Revenue Code is reduced to $500,000. In addition, the exception for qualified performance-based compensation (e.g., equity awards pursuant to shareholder approved plans) will not apply and the income from such items will count toward the $500,000 limitation. 
  • These restrictions apply to a participating banking organization’s “senior executive officers” who are the top five most highly paid executive officers whose compensation is required to be disclosed pursuant to the requirements of Item 402 of Regulation S-K under the Securities Exchange Act of 1934, as amended. These restrictions apply not only to the participating banking organization, but also to any other entity in its control group. 
  • Participating banking organizations must modify their executive compensation agreements and policies to comply with these requirements as a condition of closing on Treasury’s investment. 
  • The affected senior executive officers must grant Treasury a waiver from any claims that they may have as a result of, or modification or termination of, these plans to comport with EESA and Treasury’s implementing rules. For more information, click here to see our Client Alert 2008-175.

What is the Applications Process?

  • The federal banking agencies have agreed upon a common application form and a fairly simple applications process. The final decision is made by Treasury’s Office of Financial Stability. 
  • By Nov. 14, the banking organization must complete a brief two-page application form supplemented by a one-page description of any mergers, acquisitions, or other capital raisings that are pending or under negotiation, and the expected consummation dates. 
  • The application form asks for basic information about the banking organization, the amount of capital that will be sold to Treasury, and information about the amount of authorized but unissued preferred and common stock currently available for purchase, and the total risk-weighted assets (as reported in the most recent call report, FR-Y9 or TFR). 
  • The applicant must consult with the appropriate federal banking agency before submitting an application. If the applicant is a bank holding company, it must submit the application to both its holding company supervisor and the supervisor of its largest insured depository institution controlled by the applicant. The supervisor will review the application and forward it to Treasury with a recommendation. The Treasury will determine eligibility and allocations after consultation with the appropriate federal banking agency. 
  • As a condition to receiving Treasury approval, the applicant must agree to certain terms and conditions, and make certain representations and warranties that will be described in various agreements prepared by Treasury. The detailed investment agreement and associated documentation are not yet available, although a summary term sheet is currently available on Treasury’s website. If these materials become available subsequent to a filing, an amended application will need to be filed with updated responses to any items in the application that required prior review of the investment agreement.
  • If an applicant cannot meet all of the expected terms and conditions, including representations and warranties, by Nov. 14, a detailed explanation needs to be provided. If an applicant cannot agree to all of the terms and conditions, then the applicant may be disqualified. 
  • If Treasury grants preliminary approval to participate in the Program, the applicant will have 30 days from notification to submit the investment agreements and related documentation. If confidential treatment is requested for any submitted materials, a written request for such treatment needs to be made. 
  • Applications to participate in the Program are treated as confidential proposals submitted for review by each organization’s supervisor. 
  • Applications that are denied or withdrawn will not be disclosed. However, Treasury will provide public electronic reports detailing any completed transaction within 48 hours.

What are the Considerations in Deciding Whether to Participate in the Program?

  • The market environment is very unattractive for capital-raising. However, this is an opportunity to get a significant amount of Tier 1 capital equal to at least 1 percent of a banking organization’s risk-weighted assets, and up to 3 percent at an advantageous price. 
  • While there is a requirement of no increase in dividends so long as Treasury retains its investment, Treasury has the authority, under the right set of circumstances, to approve any increase. 
  • Management time and effort that will be devoted to this capital-raising appears to be minimal, while the role of the usually involved outside professionals (for example, investment bankers, lawyers and accountants) is kept to a minimum. 
  • With the new capital injection, management’s focus can be quickly turned to rehabilitation and growing the organization, recognizing it has a better cushion against credit deterioration. 
  • A banking organization needs to consider whether it has to make public disclosures under the securities laws that its application was denied. 
  • While bank examiners will probably seek to avoid being involved in business decision-making, the examination process will likely be more intense, and “recommendations” will carry more weight and should be very seriously considered by management for implementation. 
  • Risk management and compliance areas will be under greater examiner scrutiny, and a very possible outcome is a more conservative risk approach, probably less creativity and pushing “on the line,” and a movement toward “safer” and more standardized products. 
  • Risk management, audit and compliance programs should be developed to identify, monitor and test the banking organization’s compliance with the Program’s requirements, since regulatory examinations will definitely make that a key focus. 
  • There is an interesting dynamic at play as the banking organization and the federal banking agencies have a common interest, to see the banking organization return to health with a higher share price, and the Treasury (i.e., taxpayers) realizes a good return on its investment. 
  • Treasury’s role can be minimized since it will not have any directors on the banking organization’s board so long as dividends are consistently paid out. 
  • Since Treasury’s investment is in non-voting preferred shares, the impact on the banking organization’s earnings per share is somewhat mitigated, as is the impact on the company’s stock price—an important consideration consistent with Treasury’s objective to be eventually taken out at a higher price. 
  • The FRB expects bank holding companies that issue the Preferred Stock to appropriately incorporate the dividend features of the Preferred Stock into the organization’s liquidity and capital funding plans. 
  • Some banking organizations’ senior executives may chafe under the compensation restrictions, so they should be analyzed and netted with executives before a decision is made to apply. 
  • While a clear objective of Treasury is to increase banking organizations’ lending capacity, that is not yet a condition to participation in the Program. Participants may, however, have to comply with some foreclosure requirements similar to those that will be in a place for banking organizations participating in the TARP.
  • Neither participation in the Program nor denial under the Program precludes participation in the TARP.

Conclusion

There are three related developments that make it clear how important the Program is to Treasury. First, the FRB has issued an interim rule, effective Oct. 17, 2008, that the new Preferred Stock issued to the Treasury by a bank holding company under the Program will be included in Tier 1 capital for purposes of the FRB’s risk-based asset leverage capital rules and guidelines for bank holding companies (See Appendix A to 12 C.F.R. 225, section II.A.1.a.ii). The outstanding Preferred Shares remain subject to the 25 percent aggregate limit. The OCC and FDIC should be issuing a similar Tier 1 capital ruling very promptly. Second, an accounting issue has been raised that the warrants that are attached to the Preferred Stock would be treated as liabilities under GAAP, not a desired outcome. It appears the SEC and FASB are prepared to clarify that the warrants can be recorded as equity by the banking organizations. Finally, the IRS in its recent Notice 2008-101, issued a ruling that payments made to financial institutions under TARP will not be treated as financial assistance within the meaning of Section 597 of the Internal Revenue Code.

Many applicants should find the pricing of this capital attractive. For example, a recent issuance of $5 billion in cumulative preferred stock by Goldman Sachs (with five-year warrants) to Berkshire Hathaway bore a coupon rate of 10 percent. The same 10 percent coupon rate was attached to a $3 billion issuance of General Electric preferred stock (with five-year warrants) to Berkshire Hathaway. This compares with the favorable Preferred Stock coupon rate of 5 percent, stepping up to 9 percent after five years, under Treasury’s program.