On Tuesday, October 14, 2008, the U.S. Treasury Department announced a three pronged plan to ease the continuing credit and financial crisis. Despite the enactment of the Emergency Economic Stability Act of 2008 (“EESA”), global markets continued to decline last Thursday and Friday, resulting in the creation of a coordinated action plan by the G7 Finance Ministers late Friday, October 10. The plan announced on Tuesday is consistent with that action plan and the strategy announced by the President’s Working Group on October 6, 2008. The plan has three main components:
1. Purchasing Capital in Financial Institutions (the “TARP Capital Purchase Program”)
Under the authority of the EESA, the U.S. Treasury announced the TARP Capital Purchase Program (the “Program”) which will make available $250 billion of capital to U.S. financial institutions. This facility will allow banking organizations to sell preferred stock to the U.S. Treasury. Nine large financial organizations have already indicated their intention to subscribe to the facility in an aggregate amount of $125 billion. Those institutions include Citigroup and JPMorgan Chase, which will sell to the Treasury $25 billion of Senior Preferred Shares each. Bank of America, which is acquiring Merrill Lynch, and Wells Fargo, which is acquiring Wachovia, will also sell $25 billion each. Goldman Sachs and Morgan Stanley, who recently received approval to become registered bank holding companies, will sell $10 billion each. Bank of New York, Mellon and State Street will sell $2 billion to $3 billion. The remaining $125 billion will be used to purchase Senior Preferred Shares of medium to small size banks.
Under the program, Treasury will purchase up to $250 billion of Senior Preferred Shares on standardized terms as described in the Program’s term sheet. The Program will be available to qualifying U.S. controlled: banks, savings associations, and certain bank and savings and loan holding companies engaged only in financial activities that elect to participate before 5:00 pm (EDT) on November 14, 2008. Treasury will determine eligibility and allocations for interested parties after consultation with the appropriate federal banking agency. Treasury’s announcement of the Program stated that institutions interested in participating in the Program should contact their primary federal regulator for specific enrollment details. However, calls to the regulatory agencies indicated that guidelines for participants are still in the development process. Banks controlled by foreign entities are not eligible to participate in the plan.
The minimum subscription amount available to a participating institution is 1 percent of risk-weighted assets. The maximum subscription amount is the lesser of $25 billion or 3 percent of risk-weighted assets. Interestingly, under this format, banks with greater risk weighted assets will be able to sell more Senior Preferred Shares to the Treasury than a comparable company with fewer risk weighted assets. Treasury will fund the Senior Preferred Shares purchased under the program by year-end 2008. Presently, only publicly held banks or their holding companies appear to be eligible under the Program, with the Program requiring that the Senior Preferred Shares be issued by the top-tier entity (i.e., the holding company if in that form of organization or the bank if not). The Program does not mention credit unions, securities brokers or dealers or other companies that are expressly eligible to participate in the TARP by Section 3 (5) of the EESA. Further, while the Program does not expressly mention privately or closely held stock banks or mutual savings institutions and credit unions, reports are that Treasury has given private assurances that such entities will be eligible to participate in the Program, although the details of the form of instruments that such institutions would issue have not been finalized at this time.
The Senior Preferred Shares will qualify as Tier 1 capital and will rank senior to common stock and pari passu, which is at an equal level in the capital structure, with existing preferred shares, other than preferred shares which by their terms rank junior to any other existing preferred shares. The Senior Preferred Shares will pay a dividend rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum after year five. The dividend will be cumulative for Senior Preferred Shares issued by holding companies and noncumulative for Senior Preferred Shares issued by banks. The Senior Preferred Shares will be non-voting, other than class voting rights on matters that could adversely affect the shares. The Senior Preferred Shares will be callable at par after three years. Prior to the end of three years, the Senior Preferred Shares may be redeemed with the proceeds from a qualifying equity offering of any Tier 1 perpetual preferred or common stock. Treasury may also transfer the Senior Preferred Shares to a third party at any time. In conjunction with the purchase of Senior Preferred Shares, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15 percent of the Senior Preferred investment. The exercise price on the warrants will be the market price of the participating institution’s common stock at the time of issuance, calculated on a 20-trading day trailing average.
The Program term sheet provides that once the Senior Preferred Shares and warrants are issued, the issuer must file a shelf registration statement covering the Senior Preferred Shares, the warrants and the underlying common shares as promptly as practicable after the date of the issuance and, if necessary, take all action required to cause such shelf registration statement to be declared effective as soon as possible. The issuer must also grant to the Treasury piggyback registration rights for the Senior Preferred Shares, the warrants and the underlying common shares and take such other steps as may be reasonably requested to facilitate the transfer of the Senior Preferred Shares, the warrants and the underlying common shares including, if requested by the Treasury, using reasonable efforts to list the Senior Preferred Shares, the warrants and the underlying common shares on a national securities exchange.
Institutions selling Senior Preferred Shares to the Treasury must agree that the following executive compensation limitations will apply while the Treasury owns shares in the company: 1) the Board will certify that contracts of the top five executives do not encourage or reward excessive risk taking; 2) the company must enforce a “clawback” which requires that compensation payments made based on earnings, gains, or other criteria that are later proven to be materially inaccurate must be repaid, 3) no golden parachute payments will be made; and 4) no deduction may be taken for tax purposes for executive compensation in excess of $500,000 for each senior executive. Potential participants are strongly advised to consider these restrictions before deciding to participate in the Program. It should be noted, for instance, that the term “excessive risk taking” is vague and is still yet to be defined by the Treasury. The difficulty is that such language appears to suggest a strong bias against performance based compensation, which is counter to current compensation trends. One can interpret this to lead to a rebalancing of compensation in favor of longer term awards over shorter term compensation such as bonus and short term performance awards. With respect to the clawback provision, this statutory language is much broader than the language included in SOX and will require further definition by the Treasury. Regarding the golden parachute prohibition, the TARP utilizes the IRS definition of golden parachute which should be broad enough to provide for certain severance payments. Lastly, it should be noted that the reduction of the 162(m) limitation to $500,000 for participating companies is not a limit on executives’ salaries but rather limits the company’s deductibility for tax purposes of amounts paid in excess of $500,000. Under the TARP summary however, the Treasury clarifies the apparent inconsistency between the rules and contract rights by requiring executives to waive all rights in conflict with TARP. This could well be a sticking point in the case of an executive who has only a short period of time to retirement and may result in a negotiated early termination of the executive in order to qualify the company under TARP.
A participating institution may not repurchase any shares of stock without the Secretary of the Treasury’s consent (other than (i) repurchases of the Senior Preferred Shares and (ii) repurchases of junior preferred shares or common shares in connection with any benefit plan in the ordinary course of business consistent with past practice) until the third anniversary of the date of the investment unless prior to such third anniversary the Senior Preferred is redeemed in whole or the Treasury has transferred all of the Senior Preferred to third parties. In addition, the Treasury’s consent is required for any increase in common dividends per share until the third anniversary of the date of the investment unless prior to such third anniversary the Senior Preferred is redeemed in whole or the Treasury has transferred all of the Senior Preferred to third parties. While the issues raised above present certain challenges, they do not rise to a level that would undermine the attractiveness of being able to raise capital through issuance of Senior Preferred Shares to the Treasury.
While we expect banks to resist initially issuing shares for fear of being marked with a “Scarlet Letter,” the increased capital for growth, acquisitions and balance sheet restructuring could be too strong to ignore. Conversely, banks with assets less than $1 billion and who serve low and moderate income populations may not want to issue any Senior Preferred Shares and instead may seek to qualify for special consideration for assistance under Section 103(6) of TARP. Also, banks with a strategic plan to sell in the near future, regardless of the reason, may be better served to pass on participating in TARP and instead seek a newly recapitalized TARP participant as an acquirer. This strategy would eliminate any restrictions on compensation benefits that would normally be provided to executives in this type of transaction.
2. Guaranteeing Certain Obligations of Financial Institutions
After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and after consulting with the President, Secretary of the Treasury Paulson triggered the systemic risk exception to the FDIC Act, enabling the FDIC to temporarily guarantee the senior debt of all FDICinsured institutions and their holding companies. In addition, the FDIC will now guarantee all deposits in non-interest bearing deposit transaction accounts. Regulators will implement an enhanced supervisory framework to assure appropriate use of this new guarantee. The ability to issue guaranteed debt under the program would expire on June 30, 2009 and the full protection for deposits in non-interest bearing transaction deposit accounts would revert back to the statutory limits on December 31, 2009. Under the EESA, deposit insurance was increased from $100,000 to $250,000 until December 31, 2009.
3. Purchasing Commercial Paper
To further increase access to funding for businesses in all sectors of our economy, the Federal Reserve has announced further details of its Commercial Paper Funding Facility (CPFF) program, which provides a broad backstop for the commercial paper market. Beginning October 27, the CPFF will be able to purchase commercial paper of 3 month maturity from high-quality issuers.
4. Coordinated, Comprehensive Plan to Address Financial Market Turmoil
President Bush made clear that the United States is committed to using all necessary tools to support the financial markets and institutions, so they can finance the U.S. economy, and to continue to work closely with the international regulatory community to resolve the global financial crisis.