News + Events
United States Treasury Announces TARP Capital Purchase Program
October 17, 2008
Jacob "Jake" A. Lutz, III
In an unprecedented move, the United States Department of the Treasury (“Treasury”) announced the implementation of a Capital Purchase Program (“CPP” or “Program”) with the goal of encouraging U.S. financial institutions “to be build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy.”
This Client Alert provides a summary of the CPP and describes the institutions eligible for participation; the securities that may be issued; key terms and conditions; and other business and regulatory considerations. Under the Program, Treasury will purchase up to $250 billion of senior preferred shares on standardized terms as described in the CPP’s term sheet (“Term Sheet”), a copy of which is attached to this Client Alert. The CPP is available for participation by qualifying U.S. controlled banks, savings associations, bank holding companies; and savings and loan holding companies that elect to participate in the CPP before 5:00 PM (EDT) on November 14. Treasury will determine eligibility and allocations for interested parties after consultation with the appropriate federal banking agency.
While the Program provides some specifics, the CPP is complex and more guidance is needed in many areas. The following sets forth a description of the Program’s key terms and conditions as currently known as well as a discussion of important business and regulatory consideration.
Program Summary – Although the CPP is described by Treasury as a voluntary plan, nine of the nation’s largest financial institutions were required to participate in the Program at the initial meeting with Treasury earlier this week. In requiring participation by these institutions, the Treasury sent a clear message to the nation’s financial sectors that Treasury will be providing sufficient capital and liquidity, to the extent possible, “to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy.” It is unclear at this point whether additional U.S. financial institutions or holding companies will be required to participate in the Program. However, by its terms, the Program is open to all qualifying institutions that elect to participate before 5:00 PM (EDT) on November 14, 2008.
The principal provisions of the CPP are as follows:
- Qualifying Institutions – Qualifying financial institutions are defined as U.S. banks or savings associations, U.S. bank holding companies and savings and loan holding companies only engaging in activities permissible under Section 4(k) of the Bank Holding Company Act, and U.S. bank holding companies or savings and loan holding companies whose depository institution subsidiaries are subject to an application under Section 4(c)(8) of the Bank Holding Company Act. Foreign bank holding companies, savings and loan holding companies, banks and savings associations are not included, nor are insurance companies, credit unions or other financial service providers.
- Securities Purchased– Intended to be Tier 1 capital eligible securities for banks and bank holding companies (senior cumulative preferred for holding companies, senior non-cumulative preferred for banks) coupled with warrants to purchase a number of shares of common stock having an aggregate market price equal to 15% of the senior preferred amount on the date of investment, subject to downward adjustment as provided in the CPP.
- Amount of Securities – Each institution may issue an amount of senior preferred not less than 1% of risk-weighed assets nor more than 3% of risk-weighed assets, subject to an individual institution cap of $25 billion.
- Transferability – The initial holder will be the Treasury. Both senior preferred and warrants will be transferable and carry mandatory registration rights.
- Voting Rights – The senior preferred will be non-voting but warrants issued will be for the purchase of voting common, equal in value to 15% of the senior preferred.
- Dividends – Senior preferred carries a 5% coupon for five years adjustable to 9% thereafter. Senior preferred issued by banks which are not subsidiaries of holding companies will pay non-cumulative dividends in arrears commencing on February 15, 2009 and occurring quarterly thereafter.
- Dividend Restrictions – As long as any senior preferred is outstanding, no dividends may be declared or paid on junior preferred shares, preferred shares ranking equal with the senior preferred, or common shares (unless in the case of cumulative senior preferred, all accrued and unpaid dividends are fully paid, or in the case of non-cumulative senior preferred, the full dividend for the last completed dividend period has been declared and paid). Treasury may consent to an increase in common dividends per share prior to the third anniversary of the investment date unless prior to the third anniversary the senior preferred is redeemed in whole by the institution or transferred by Treasury to a third party.
- Repurchases – Treasury’s consent shall be required for any share repurchases other than the senior preferred or junior preferred shares or common shares in connection with any benefit plan in the ordinary course of business consistent with best practices until the third anniversary date of the investment.
- Executive Compensation Limits – Certain compensation limits will be imposed on any participating institution as long as the senior preferred and/or warrants are outstanding, as described below.
- Deadline – The Program specifically states that it is open to all institutions that elect to participate on or before November 14, 2008. While such notice on or before that date should be sufficient, institutions should apply or express intent to their primary federal regulator as soon as possible.
On balance, the terms of the Program should encourage the participation of institutions requiring additional capital, especially in the current environment when sources of private capital are substantially limited. Positive factors include prompt access to capital, the ability to continue payment of common stock dividends, the relatively low coupon on the senior preferred (5%) during the initial five year period, and the relatively low warrant coverage ratio (15%). Also important is the fact that all capital issued under the Program is designed to qualify as Tier 1 capital. On the other hand, however, limitations on executive compensation and possible higher levels of government scrutiny are somewhat negative factors. Unknown at this point is the extent to which a stigma may attach in the marketplace to those institutions that do chose to participate in the Program.
Additional Qualifying Institutions Considerations –Qualifying Institutions that may participate in the Program are described above. Some additional considerations for certain institutions are as follows:
- Failing Institutions – It is unlikely that Treasury will provide any assistance to an institution which is identified by the primary federal regulator as likely to fail.
- Sub S Institutions – The guidance provided by Treasury is silent on this issue, but the American Bankers Association has stated that it has been informed by Treasury that Sub S corporations will be eligible to participate. The question that Treasury is addressing is whether senior preferred stock owned by the Treasury under the Program would constitute a prohibited second class of stock in a Sub S bank under IRS rules. The ABA has continued to work with Treasury on this issue with a goal of ensuring participation for Sub S banks. Importantly, recent amendments to the Sub S rules have made Sub S tax election more popular for financial institutions, a number of which have restructured during recent years to take advantage of the tax efficiencies through a Sub S structure.
- Mutual Institutions – Mutual Institutions operating under mutual holding companies are eligible to sell senior preferred shares to Treasury that would be compliant with the Program. Although provisions have been made for mutual institutions that have not converted to a mutual holding company structure, Treasury has indicated that the Program will apply to mutuals. The ABA is proposing corrective Program guidance on this point.
- Banks With Holding Companies Not Authorized To Issue Preferred Stock – Many community bank holding companies are not authorized by their organizational documents to issue preferred stock. The guidance from Treasury suggests that banks in a holding company structure can still participate at the bank level. Such participation makes unclear the issue of registration of the preferred stock or the warrants and complicates the efficiencies found in having the institution held as a wholly-owned subsidiary of the bank holding company. More guidance on this issue will be helpful as well.
Preferred Stock and Warrants – The Program provides that Treasury will purchase senior preferred stock coupled with warrants to purchase common stock having an aggregate market value equal to 15% of the senior preferred amount on the date of investment subject to reduction as described in the plan. Because not all holding companies have articles of incorporation which authorize preferred stock, and because such authorization would require shareholder approval, it is unclear whether holding companies and institutions without authorized preferred stock may participate in the Program in view of the November 14, 2008 deadline. Additional clarification is required here, although it would appear logical that a participation election could be made subject to subsequent shareholder approval. Importantly, page 5 of the Purchase Plan notes that if a Qualified Financial Institution does not have sufficient available authorized shares of common to reserve for issuance of warrants and/or stockholder approval is required for the issuance under applicable stock exchange rules, the Qualified Financial Institution may call a meeting of its stockholders as soon as practicable after the date of the investment to increase the number of authorized shares of common stock and/or comply with such exchange rules, and take any other measures deemed necessary by Treasury to allow the exercise of warrants into common stock. By analogy, therefore, other after-the-fact shareholder approvals should be permissible.
Transferability and Registration of Shares – The Program requires both the preferred stock and common stock to be transferable without contractual restrictions. The Program requires Qualified Financial Institutions to file a shelf registration statement covering the senior preferred as promptly as practicable after the date of the investment and for the issuer to request that the registration statement be declared effective as soon as possible. The Qualified Financial Institution is also required to grant to Treasury piggyback registration rights for the senior preferred and take such other steps as may be reasonably requested to facilitate the transfer of the senior preferred including, if appropriate, seeking a listing on a national securities exchange. Similarly, the Qualified Financial Institution is required to file a shelf registration statement covering the warrants and common stock underlying the warrants as soon as practicable after the date of the investment and is subject to the piggyback registration rights, accelerated effectiveness, and exchange listing considerations described with regard to the preferred shares. As a practical matter, holding companies and national banks (which are subject to ‘33 Act registration requirements with the OCC) would use the most efficient registration and therefore must be Form S-3 eligible, which means that the institution is a reporting company that has filed on a timely basis all current and periodic reports required for the previous 12-month period. For holding companies and banks not Form S-3 eligible, it would be time consuming and expensive to prepare registration on a form other than an S-3.
Voting Rights – The senior preferred is non-voting, other than class voting rights regarding authorization or issuance of shares with a senior preference, amendment to the rights of the senior preferred, or any merger, exchange or other similar transaction which would adversely affect the rights of the senior preferred. Similarly, there are no voting rights in connection with the shares of common stock of the Qualified Financial Institution issued upon exercise of the warrants.
Executive Compensation Limits – Treasury has expressly imposed executive compensation limits for institutions participating in the Capital Purchase Program and the Troubled Asset Auction Program, as set forth in the attached Treasury announcement. Specifically, any Qualified Financial Institution participating in the Capital Purchase Program will be subject to more stringent executive compensation rules for the period during which Treasury holds equity issued under the Program. The financial institution must meet certain standards, including: (1) insuring that the incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) requiring claw-back of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate; (3) prohibiting the financial institution for making any golden parachute payment to a senior executive based on the Internal Revenue Code provisions; and (4) agreeing not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. Treasury is in the process of issuing interim final rules for these executive compensation standards.
Business and Regulatory Considerations – The Capital Purchase Program presents an unprecedented opportunity for holding companies and financial institutions to participate in a program providing for U.S. government ownership of preferred and common stock of these institutions. This opportunity comes at a time in which traditional capital markets are struggling to provide capital and liquidity. For institutions that have current or anticipated capital needs without identified sources of capitalization, the Capital Purchase Program comes at an ideal time, but not without risks. The risks of participation in the Program are significant. First, the preferred stock at the holding company carries a cumulative dividend which may be difficult for some institutions to service. Second, the limits on executive compensation may compromise the institution’s ability to attract and retain qualified management. Third, although the preferred and common securities are non-voting, Treasury and the bank regulatory agencies have plenary authority to investigate and control, albeit indirectly, the activities and operations of all U.S. chartered financial institutions. Hence, it is unclear what future operating restrictions or other government restrictions and operations or activities may be imposed.
Importantly, the final terms of the Capital Purchase Program have not been released. It is unknown what additional terms and conditions may be imposed on institutions that are participants. It is also unclear what market stigma may evolve as a result of program participation. Treasury is providing additional guidance and information as promptly as possible.