Financial Institutions Weigh Benefits and Costs of Participating in the Capital Purchase Program

By: KAREN L. GRANDSTRAND & KARLA L. REYERSON

November 21, 2008

Shortly after the passage of the Emergency Economic Stabilization Act of 2008, the U.S. Treasury used its authority under the new law to create a program to infuse capital into U.S. financial institutions. The Capital Purchase Program (CPP) provides for the Treasury to purchase up to $250 billion in equity interests in U.S. financial institutions.

The Treasury has issued term sheets and deadlines for participation in the CPP for entities whose securities are traded on a national securities exchange (Publicly Traded Entities) and for other  entities, except S corporations and mutual institutions (Nonpublic C Corporations). The Treasury has indicated that it will publish a separate term sheet and application deadline for S corporations and mutual institutions to apply for participation in the CPP.

Below is a summary of the CPP. While several of the requirements for Publicly Traded Entities and Nonpublic C Corporations are identical, we note several important differences. The extent to which these requirements will differ for S corporation and mutual institutions is not yet known.

Eligibility:

• All domestic banks, thrifts and holding companies are eligible for participation.
• The Treasury will purchase capital from successful applicants at the highest-tier holding company level for banks that have a holding company. The Treasury will invest directly in successful bank applicants that do not have a holding company.
• The Treasury and the federal regulators reviewing the application (see Applications below) will determine whether to accept or deny an entity’s application.
• The extent to which institutions rated CAMELS 3, 4 or 5 will be allowed to participate is not clear, but the government is encouraging such institutions to contact their regulators and apply if interested.

Deadline to Apply:

• Publicly Traded Entities: November 14, 2008
• Nonpublic C Corporations: December 8, 2008
• S Corporations and Mutual Institutions: To be determined

Preferred Shares:

• The Treasury will purchase perpetual preferred shares (Preferred Shares) totaling between 1% and 3% of the risk-weighted assets of the entity.
• Applicants must indicate in their applications the dollar amount of the investment they are requesting.
• These shares will be considered Tier 1 capital.
• The Preferred Shares must be senior to common shares and pari passu with existing preferred shares, except that the Preferred Shares will be senior to any preferred shares that, by their terms, are junior to other existing preferred shares.
• The Preferred Shares may not be subject to any contractual restrictions on transfer.
• The Treasury and its transferees will have piggyback registration rights.
• The entity may be required to perform additional steps to facilitate transfer of the Preferred Shares as requested by the Treasury.
• Terms Applicable to Publicly Traded Entities only:
• The Preferred Shares are referred to as Senior Preferred Shares.
• Entities must file a shelf registration statement for the Preferred Shares.
• Terms Applicable to Nonpublic C Corporations only:
• The Preferred Shares will not be subject to the restrictions of any stockholders’ agreement or similar arrangement that is in effect among the entity and its stockholders at the time of the Treasury’s investment or thereafter.
• The Treasury and its transferees will not effect any transfer of the Preferred Shares which would require the entity to become subject to the periodic reporting requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934 (Exchange Act).
• If the entity otherwise becomes subject to Section 13 or 15(d) of the Exchange Act, the entity will file a shelf registration statement covering the Preferred Shares.

Cost of Preferred Shares:

• The Preferred Shares will pay a cumulative dividend rate of 5% for five years, after which the rate will increase to 9%. Shares purchased directly from a bank because there is no holding company will be noncumulative.
• The shares will carry a $1,000/share liquidation premium.
• The dividends paid to the Treasury will not be tax deductible.

Redemption:

• The Preferred Shares may not be redeemed during the first three years following the investment unless:
• The entity funds the redemption using only proceeds from a Qualified Equity Offering (meaning a sale by the entity, after the date of the investment, of Tier 1 qualifying perpetual preferred stock or common stock for cash); AND
• The Qualified Equity Offering results in aggregate gross proceeds equal to 25% or more of the price of the Preferred Shares when they were issued.
• After three years the entity may redeem the shares at will.
• All redemptions are subject to the approval of the entity’s primary federal bank regulator.
• Terms Applicable to Publicly Traded Entities only:
• After the Preferred Shares have been fully redeemed, the entity may repurchase any other equity security the Treasury holds in the entity at fair market value.
• Terms Applicable to Nonpublic C Corporations only:
• A Qualified Equity Offering does not include sales made pursuant to agreements or arrangements entered into, or pursuant to financing plans which were publicly announced, on or prior to November 17, 2008.

Voting Rights of Preferred Shares:

• The Preferred Shares will not have voting rights, except that there will be class voting in the following situations:
• The entity is authorizing or issuing shares that would be senior to the Preferred Shares;
• The entity is amending the rights of the Preferred Shares; or
• The entity is executing a merger, exchange or similar transaction that would adversely affect the Preferred Shares.
• The Preferred Shares will gain the right to elect two directors after the entity has failed to pay dividends on the shares in full for six periods, whether or not consecutive.
• Terms Applicable to Publicly Traded Entities only:
• The Preferred Shares will lose the right to elect the directors after the entity has paid dividends on the shares in full for four consecutive dividend periods.
• Terms Applicable to Nonpublic C Corporations only:
• The Preferred Shares will lose the right to elect the directors when dividends have been paid in full for:
• All prior dividend periods in the case of cumulative Preferred Shares; or
• Four consecutive dividend periods in the case of noncumulative Preferred Shares.

Restrictions on Share Repurchases:

• Terms Applicable to Publicly Traded Entities only:
• During the first three years after the Treasury makes its investment, an entity must obtain the Treasury’s consent prior to repurchasing shares of the entity unless:
• The Preferred Shares have been fully redeemed;
• The Treasury has transferred all of the Preferred Shares to third parties; or
• The entity is repurchasing common or junior preferred shares in connection with a benefit plan in the ordinary course of business and consistent with past practices.
• Terms Applicable to Nonpublic C Corporations only:
• During the first ten years after the Treasury makes its investment, an entity must obtain the Treasury’s consent prior to repurchasing equity securities or trust preferred securities of the entity unless:
• The Preferred Shares and Warrant Preferred Shares have been fully redeemed (see Warrants for Preferred Shares below);
• The Treasury has transferred all of the Preferred Shares and Warrant Preferred Shares to third parties; or
• The entity is repurchasing common or junior preferred shares in connection with a benefit plan in the ordinary course of business and consistent with past practices.
• Repurchases are also not allowed if dividend payments on the Preferred Shares are not current.

Restrictions on Dividends:

• An entity must pay dividends owed on the Preferred Shares prior to declaring or paying dividends on other shares or repurchasing or redeeming other shares.
• Terms Applicable to Publicly Traded Entities only:
• For the first three years after the investment is made, an entity must obtain the Treasury’s consent prior to increasing its common share dividends unless the Preferred Shares have been fully redeemed or have been transferred to third parties.
• Terms Applicable to Nonpublic C Corporations only:
• For the first three years after the investment is made, an entity must obtain the Treasury’s consent prior to increasing its common dividends per share unless the Preferred Shares and Warrant Preferred Shares have been fully redeemed or have been transferred to third parties.
• After the third anniversary of the Treasury’s investment but prior to the tenth anniversary, the Treasury’s consent will be required for any increase in aggregate common dividends per share that are greater than 3% per annum; no increase in common dividends will be allowed as a result of a dividend paid in common shares, a stock split or a similar transaction.
• The Treasury may make certain exceptions regarding the restrictions on the payment of dividends.

Other Restrictions Applicable Only to Nonpublic C Corporations:

• On or after the tenth anniversary of the Treasury’s investment, an entity may not pay common dividends or repurchase any equity securities or trust preferred securities until one of the following events occurs:
• The entity redeems all of the equity securities of the entity held by the Treasury; or
• The Treasury transfers all of the equity securities to third parties.
• For as long as the Treasury holds equity securities of an entity, the entity and its subsidiaries may not enter into transactions with related persons unless the transactions:
• Are on terms no less favorable to the entity and its subsidiaries than could be obtained from an unaffiliated third party; and
• Have been approved by the audit committee or independent directors of the entity.

Executive Compensation Restrictions:

• Participants in the CPP must agree to certain restrictions on executive compensation during the period the Treasury has an equity or debt interest in the entity.
• The compensation restrictions apply to the participant’s CEO and CFO, as well as the next three most highly paid executive officers of the entity (Senior Executive Officers). (A bank holding company must look at its own executives and the executives of its bank subsidiaries to determine the next three most highly paid executive officers, other than the holding company’s CEO and CFO.)
• The compensation restrictions are as follows:
• Senior Executive Officers may not receive incentives to take unnecessary and excessive risks that threaten the value of the financial institution.
• Senior Executive Officers must return any bonus or incentive compensation that was based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.
• Senior Executive Officers may not receive any golden parachute payment upon involuntary termination or in connection with an entity’s bankruptcy filing, insolvency or receivership.
• Entities must agree not to claim deductions for compensation in excess of $500,000 during a taxable year for any of these executives.

Warrants for Common Shares (applicable only to Publicly Traded Entities):

• The Treasury will receive warrants to purchase common shares of the entity having an aggregate market value equal to 15% of the Preferred Shares amount on the date of investment.
• The warrants have a 10-year term, are immediately exercisable and must be freely transferable, except that the Treasury will not transfer or exercise an aggregate of one half of the warrants prior to the date on which the entity has received aggregate gross proceeds equal to or greater than the issue price of the Preferred Shares from one or more Qualified Equity Offerings or December 31, 2009, whichever is earlier.
• If, by December 31, 2009, an entity receives aggregate gross proceeds from one or more Qualified Equity Offerings that are equal to or greater than the issue price of the Preferred Shares, then the number of common shares underlying the warrants will be reduced by half.
• Both the market price for determining the number of common shares subject to the warrants, as well as the initial exercise price of the warrants, will be determined by the 20-trading-day trailing average of common stock as of date of the Treasury’s investment.
• The Treasury will agree not to exercise voting power for any common shares it is issued upon exercising the warrants.
• If shareholder approval is required to authorize the shares needed for the warrants or due to stock exchange rules, the exercise price of the warrants will be reduced by 15% every six months (with maximum reduction of 45%) that the shareholders fail to give the required consent.
• The Treasury will have the option to exchange the warrants for senior term debt or another economic instrument or security if one of the following occurs:
• The entity is no longer listed or traded on a national securities exchange or securities association; or
• Any necessary shareholder consent (as described above) is not obtained within 18 months after the entity issues the warrants to the Treasury.

Warrants for Preferred Shares (applicable only to Nonpublic C Corporations):

• The Treasury will receive warrants to purchase a number of Preferred Shares having an aggregate liquidation preference equal to 5% of the Preferred Shares amount on the date of investment (Warrant Preferred Shares).
• The initial exercise price for the warrants will generally be the par value per share.
• The warrants have a 10-year term and are immediately exercisable.
• The Treasury intends to immediately exercise the warrants.
• The Warrant Preferred Shares have the same rights, preferences, privileges, voting rights and other terms as the Preferred Shares, except:
• The Warrant Preferred Shares will pay dividends at a rate of 9% per annum; and
• The Warrant Preferred Shares may not be redeemed until the Preferred Shares have been redeemed.
• The warrants must not be subject to any contractual restrictions on transfer or restrictions of any stockholders’ agreement or similar arrangement.
• The Treasury will not effect any transfer of the warrants or Warrant Preferred Shares which would require the entity to become subject to the periodic reporting requirements of Section 13 or 15(d) of the Exchange Act.
• If the entity otherwise becomes subject to Section 13 or 15(d) of the Exchange Act, the entity will file a shelf registration statement covering the warrants and Warrant Preferred Shares.
• The Treasury will not require warrants for certified Community Development Financial Institutions (CDFIs), or those entities that apply for CDFI certification by December 8, 2008, provided the Treasury investment in the entity is $50 million or less.
• Entities must complete their CDFI application (if they are not already certified) on or before the date they apply for CPP funds in order to qualify for the warrant exemption. Their CDFI applications must also be approved by January 15, 2009 and at or before closing of the CPP investment. The CDFI Fund has pledged to streamline the application process to 30 days to assist entities in meeting CPP deadlines.
• CDFIs are specialized financial institutions that work in markets that are underserved by traditional financial institutions. They provide a unique range of financial products and services in economically distressed target markets.
• CDFI certification is obtained through the CDFI Fund. .

Applications:

• As of this publication, the Treasury has not indicated whether Nonpublic C Corporations will use the same application as the Publicly Traded Entities or be required to submit any additional or different information than Publicly Traded Entities as part of the application.
• A holding company that submits an application must send it to the Federal Reserve AND the federal regulator of the largest bank it controls. A bank that does not have a holding company must submit the application to its primary federal regulator. These regulators must be contacted prior to the submission of the applications.
• Each applicant is required to describe any condition, including any representation or warranty, contained in the investment agreements and related documentation it must execute, with which the applicant cannot comply. The applicant may do this on the application or may attach a one-page explanation.
• The applicant must provide a description (no longer than one page) of any mergers, acquisitions, or other capital raisings that are currently pending or are under negotiation, including the expected consummation date.
• The CEO or an authorized designee must sign the application.
• Regulators may request additional information to accompany the applications.

Other Considerations:

• Currently there are no use requirements for the funds that participants obtain through the CPP. The Securities Purchase Agreement that Publicly Traded Entities must execute contains recitals stating that participants agree to “expand the flow of credit to U.S. consumers and businesses on competitive terms” and “work diligently, under existing programs, to modify terms of residential mortgages as appropriate.” The agreement does not contain any contractual requirement to do these things. However, the use of the funds is under political scrutiny, so additional use restrictions could be placed on the funds in the future.
• Entities need to identify any corporate governance impediments or tasks to complete in order to comply with the requirements of the CPP. These may include:
• Preemptive rights
• The need to amend the entity’s articles (and perhaps the bylaws) to authorize the necessary shares
• Shareholder agreements or other agreements that may apply to the shares and affect their transferability
• Compensation agreements, stock option agreements, or other agreements that may need to be modified in order to comply with the executive compensation restrictions.
• Each entity should identify any information contained in the application which it desires to keep confidential and request confidentiality for such information.
• It is unknown whether a stigma will be placed on entities that apply or do not apply.
• The Treasury has indicated that applicants will be able to withdraw their applications under the CPP and that such withdrawals will not be made public. The Treasury also will not disclose any applications that are denied.

Takeaway

The CPP provides a unique method for financial institutions to raise capital. While the deadline for application to participate has passed for Publicly Traded Entities, Nonpublic C Corporations have until December 8, 2008 to apply for CPP funds. Meanwhile, S corporations and mutual institutions continue to wait for their own term sheet and application deadline. Each institution has much to consider in a short period of time to determine whether participation in the CPP makes sense.