On October 14, 2008, the U.S. Department of the Treasury (Treasury) announced the availability of its voluntary Troubled Assets Relief Program (TARP) Capital Purchase Program (CPP) for qualifying U.S.-controlled banks, savings associations, and certain bank and savings-and-loan holding companies. Through the CPP, the Treasury seeks to enhance the capital bases of domestic financial institutions in an effort to thaw the credit markets and enable the flow of financing to businesses and consumers. The Treasury has already disbursed more than $190 billion to participating financial institutions and continues to process applications.
The CPP’s first phase, which was oriented toward publicly traded financial institutions, had an application deadline of November 14, 2008. The CPP’s second phase, which was oriented toward certain privately held institutions (but excluded S corporations and mutual organizations), had an application deadline of December 8, 2008.
On January 14, 2009, the Treasury issued a term sheet for S corporations to participate in a third phase of the CPP. The application deadline for qualifying S corporations is February 13, 2009. The primary provisions of the term sheet are summarized below. The remaining Treasury documentation relating to the S corporation program has not yet been published.
Which Institutions Are Eligible?
For this phase of the CPP, a Qualifying Financial Institution (QFI) is a corporation that has made a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code and also is one of the following:
- A top-tier bank-holding company (BHC) or savings-and-loan holding company (SLHC) that engages solely or predominantly in activities permissible for financial holding companies
- A bank or savings association that is not controlled by a BHC or SLHC
- A bank or savings association that is a qualifying S corporation subsidiary, and is controlled by a BHC or SLHC which both (a) is an S corporation and (b) does not engage solely or predominantly in activities that are permitted for financial holding companies under relevant law
Although in some cases, closer investigation may be required to determine which entity (parent or subsidiary) should apply, the definition of QFI appears designed to channel funds to top-tier entities (BHCs or SLHCs), except in the case of banks or savings associations that are standalone or are controlled by holding companies primarily engaged in non-financial activities.
What Is the Application Process?
Applying to the CPP is a three-stage process.
First, an interested institution should contact its appropriate federal banking agency prior to filing the first application.
Second, while the initial application form for the S corporation program has not yet been published, it is likely to be similar to the two-page form used for earlier phases of the CPP. This form requires the provision of basic information about the applying institution and the amount of capital requested from the Treasury.
Third, following the receipt of preliminary approval by the Treasury, an applicant will need to execute additional agreements in order to close the transaction. For S corporations, these agreements have not yet been published.
Applicants may request confidential treatment for separately bound portions of the application. However, any completed transactions (CPP investments) will be made public in electronic format within 48 hours of execution.
How Much Capital Can Be Obtained From the CPP?
Each QFI may issue an amount of senior securities (discussed below) between one percent and three percent of risk-weighted assets, subject to a maximum of $25 billion.
What Are the Characteristics of the Investment?
Unlike the earlier phases of the CPP, the S corporation program does not involve the issuance of preferred stock to the Treasury. Instead, the Treasury will purchase subordinated debentures named “senior securities,” each of which is a 30-year note in the principal amount of $1,000. Unless otherwise specified, each senior security issued by a bank or savings association will be expressly subordinated to the claims of depositors and general and unsecured creditors, and each senior security issued by a holding company will be subordinated to senior indebtedness in accordance with applicable holding company regulations.
Senior securities will pay quarterly interest at a rate of 7.7 percent per annum for the first five years, then 13.8 percent thereafter. Because the interest paid may be deducted by the issuing institution, these nominal rates are designed (assuming a 35 percent tax rate) to yield after-tax effective rates of 5 percent and 9 percent, respectively, which is commensurate with the dividend payments required under the earlier, equity-based phases of the CPP.
QFIs that are holding companies may defer the payment of interest for up to 20 quarters, but unpaid interest will accrue and compound at the applicable rates. Principal and accrued interest will become immediately due and payable in the event that a holding company defers interest beyond 20 quarters or if a holding company (or one of its major bank subsidiaries) is subject to bankruptcy or liquidation. For QFIs that are banks or savings associations, principal and accrued interest becomes immediately due and payable upon receivership.
Senior securities will be non-voting, except for certain votes affecting the rights of the senior securities. However, if interest on the senior securities is not paid in full for any six quarterly interest periods (whether consecutive or not), the Treasury (or subsequent holders of the senior securities) will have the right to elect two directors to the board of the QFI, until such time as the full interest has been paid for all prior interest periods.
The Treasury investment in senior securities will qualify as Tier 1 regulatory capital for holding companies (pending appropriate regulations) and Tier 2 regulatory capital for banks or savings associations.
How and When May the Senior Securities Be Redeemed?
A QFI may redeem the senior securities prior to the third anniversary of the investment only by using the proceeds from the sale of capital qualifying for at least the same tier or higher of regulatory capital as the senior securities, and then only if the aggregate gross proceeds from the sale amount to 25 percent or more of the issue price of the senior securities.
After the third anniversary, the senior securities may be redeemed at the option of the QFI at any time and in any series of transactions. All redemptions require the approval of the appropriate federal banking agency and must be at 100 percent of the issue price plus any accrued and unpaid interest.
What Restrictions Apply to Preferred or Common Shares?
The Treasury may decide to transfer outstanding senior securities to outside investors. Accordingly, the senior securities may not be subject to any contractual restrictions on transfer (except that the Treasury and its transferees will not effect any transfer that requires the participating institution to become subject to periodic reporting requirements under Sections 13 or 15(d) of the Securities Exchange Act of 1934).
Dividends: As long as any of the senior securities are outstanding, no dividends may be declared or paid on any shares of equity or trust-preferred securities and no such shares may be redeemed, unless all accrued and unpaid interest for the senior securities is fully paid.
Also, until the senior securities are fully redeemed (or transferred by the Treasury to certain unaffiliated third parties), the Treasury’s consent is required for (a) any increase in common dividends per share during the first three years, and (b) any increase in common dividends per share of greater than three percent per annum from the third anniversary until the tenth anniversary of the investment. After the tenth anniversary, the senior securities must be redeemed in whole before any dividends may be declared or paid on any equity or trust-preferred securities. However, the Treasury’s consent is not required for increases in “tax distributions” that are solely proportionate to the increase in the QFI’s taxable income, provided that such increases are distributed to shareholders to fund their individual tax payments on the allocable taxable income.
Redemptions: Until the tenth anniversary of the investment, all repurchases of equity or trust-preferred securities require the Treasury’s consent (except for certain repurchases in connection with benefit plans in the ordinary course of business, consistent with past practice or relevant income tax laws). After the tenth anniversary, the senior securities must be redeemed in whole before any equity or trust-preferred securities may be repurchased.
What Warrants Are Required?
In connection with an institution’s issuance of senior securities, the Treasury will receive warrants to purchase additional senior securities (the warrant securities) in an amount equal to five percent of the amount of senior securities originally purchased. For example, if the Treasury makes a $10-million investment in the senior securities of a QFI, the Treasury also will receive warrants to purchase additional senior securities totaling $500,000.
The exercise price for each warrant will be $0.01 per note. Warrants will have a 10-year term (notwithstanding the fact that the warrant securities will have a 30-year term), will be immediately exercisable (in whole or in part) by the Treasury, and will not be subject to any contractual restrictions on their transfer.
The warrant securities will have the same rights and other terms as the original senior securities, except that (i) interest will be paid at a rate of 13.8 percent per annum (rather than starting at 7.7 percent as in the case of senior securities), and (ii) no warrant securities may be redeemed until all of the senior securities have been redeemed.
What Are the Restrictions on Executive Compensation and Governance?
As a condition of accepting a capital infusion from the Treasury, a QFI must agree to certain restrictions on executive compensation. These restrictions apply for as long as the Treasury holds any equity or debt securities of the QFI. The restrictions apply to the chief executive officer (CEO), chief financial officer (CFO), and the three other most highly compensated senior executives in the QFI’s controlled group (rather than the QFI alone).
Although the Treasury has not yet issued guidance specific to S corporations, the following four limitations applicable to publicly held institutions are indicative of the Treasury’s likely approach:
- The prohibition of bonuses or incentives that reward senior executive officers (SEOs) for taking “unnecessary and excessive risks” that “threaten the value” of the financial institution.
- Required “clawbacks” of any SEO bonus or incentive compensation based upon financial statements or criteria that are later proven materially inaccurate. This (a) applies to all SEOs (not just CEO and CFO); (b) has no time limit on the recovery period; and (c) is not limited just to inaccurate financial statements.
- The prohibition of the financial institution making any “golden parachute payment” to any SEO.
- The QFI must agree to limit a claim for any federal tax deduction for any SEO compensation that exceeds $500,000 per year (whether actual or deferred). It does not matter if the compensation is “performance-based” or not.
Restrictions on Related-Party Transactions
For as long as the Treasury holds any debt or equity securities of the QFI, including the senior securities, the QFI and its subsidiaries may not enter into transactions with related persons unless such transactions: (i) 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 of the QFI (subject to certain exceptions in situations where there are no independent directors).
The preceding sections summarize the key provisions of the CPP term sheet applicable to S corporations. Because each financial institution faces unique circumstances, please consult with legal and financial counsel on any questions about the CPP and meeting the application deadline of February 13, 2009.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.
If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:
Patricia J. Lane
Stephen B. Waller