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Karla Reyerson

Karla L. Reyerson Bank & Finance

kreyerson@fredlaw.com
612.492.7418
Printable Version

Financial Institutions Consider Participation in the Treasury’s Capital Purchase Program

By: KARLA L. REYERSON

March 2009

For the past several months, one of the biggest questions on the minds of America’s bankers has been whether to accept the government’s offer to invest in their banks and holding companies. On October 14, 2008, the U.S. Treasury announced its Capital Purchase Program (“CPP”), a measure designed to infuse up to $250 billion in capital into U.S. financial institutions. The CPP is part of the $700 billion Troubled Asset Relief Program that Congress created through its passage of the Emergency Economic Stabilization Act (“EESA”) on October 3, 2008.

The specific terms for participation vary somewhat among the different types of institutions, but the basic characteristics are the same. Those entities that are publicly traded on a national securities exchange (“Publicly Traded Entities”) were the first to receive a term sheet, followed by privately held C corporations (“Nonpublic C Corporations”) and then S corporations (“S Corporations”). The term sheet for mutual institutions has not yet been released. Below is a general description of the terms for participation, including highlights of how certain terms vary among entity types.

Eligibility and Application


The deadline for most entities to apply to participate in the CPP has passed, though the process of approving institutions to receive funding is likely to continue for some time. The application deadlines were as follows:

  • Publicly Traded Entities: November 14, 2008
  • Nonpublic C Corporations: December 8, 2008
  • S Corporations: February 13, 2009
  • Mutual Institutions: To be determined

The Treasury is purchasing capital from successful applicants at the highest-tier holding company level or directly from bank applicants with no holding company. Applicants have the ability to withdraw their applications any time before closing. The Treasury has indicated that it will not disclose the identity of entities that either withdraw their applications or are denied participation in the CPP.

Investment Vehicle


For Publicly Traded Entities and Nonpublic C Corporations (together referred to here as “C Corporations”), the Treasury will purchase perpetual preferred shares (“Preferred Shares”) totaling between 1% and 3% of the risk-weighted assets of the entity. These shares are considered Tier 1 capital. They must be senior to common shares and generally must be pari passu with existing preferred shares. The Preferred Shares may not be subject to any contractual restrictions on transfer.

The Treasury will not take stock in S Corporations because doing so would cause such entities to lose their Subchapter S status. Instead it will purchase subordinated debentures (“Senior Securities”).

As with C Corporations, the Treasury will purchase Senior Securities from S Corporations totaling between 1% and 3% of the risk-weighted assets of the entity. The Senior Securities will be considered Tier 1 capital when purchased from holding companies and Tier 2 capital when purchased from banks. The Senior Securities will be senior to the entity’s common stock but generally will be subordinated to claims by depositors and other debt obligations of the entity. The Senior Securities may not be subject to limitations on transfer.

Cost


When the Treasury purchases Preferred Shares in C Corporations, such shares will earn a dividend rate of 5% for the first five years, after which the rate will increase to 9%. The shares will carry a $1,000/share liquidation premium.

The cost of the Senior Securities issued to S Corporations will be $1,000 per note with a 30-year maturity. The Senior Securities will pay interest at a rate of 7.7% for the first five years, after which the rate will increase to 13.8%. These rates are higher than the 5% and 9% rates under the C Corporation programs because unlike the dividends paid on the Preferred Shares, the interest paid on the Senior Securities is tax deductible. Assuming a 35% tax rate, the after-tax effective rate on the Senior Securities equals the dividend rates C Corporations are paying.

Redemption


Generally, participants are restricted from redeeming the Treasury’s investment during the first three years unless the entity funds the redemption using only proceeds from certain securities offerings that meet Treasury requirements. After three years the entity may redeem the Preferred Shares or Senior Securities at will, subject to the approval of the entity’s primary federal banking regulator.

Voting Rights


Neither the Preferred Shares nor the Senior Securities have voting rights, although class voting rights apply in circumstances where the holders’ rights may be negatively impacted (e.g., a merger). The Preferred Shares or Senior Securities holders will gain the right to elect two directors after the entity has failed to pay the dividends or interest owed for six periods, whether or not consecutive.

Restrictions on Share Repurchases


Publicly Traded Entities must obtain the Treasury’s consent prior to repurchasing any shares of the entity for the first three years after the Treasury’s investment, unless the Treasury no longer holds any of the Preferred Shares or, in some cases, the purchase is made in connection with a benefit plan. For Nonpublic C Corporations, the period in which Treasury’s consent must be obtained is extended to 10 years. S Corporations also must receive Treasury consent in order to repurchase equity securities or trust preferred securities for 10 years following the investment. Repurchases are not allowed for any participant whose interest or dividend payments are not current.

Restrictions on Dividends


All CPP participants are subject to certain restrictions on the payment of dividends, though the specific contours of the restrictions vary for each type of institution. CPP participants must pay the dividends or interest owed to the Treasury prior to declaring or paying dividends on shares (or, for S Corporations, trust preferred securities) and must obtain Treasury’s consent prior to increasing common dividends unless the Treasury’s investment has been redeemed or transferred. Nonpublic C Corporations and S Corporations face additional restrictions following the third anniversary if the Treasury’s investment has not been redeemed or transferred.

S Corporations are allowed to increase dividends without the Treasury’s consent when the increase is solely proportionate to the increase in taxable income of the entity and distributed in order to cover the income taxes the shareholders must pay on the entity’s income.

Executive Compensation Restrictions


All participants must agree to restrictions on executive compensation during the time that the Treasury holds their entity’s equity or senior debt. These include the following:

  • Restrictions on incentives to take unnecessary and excessive risks that threaten the value of the financial institution;
  • Clawbacks on paid bonuses and incentive compensation that were based on materially inaccurate earnings or other criteria;
  • Restrictions on golden parachute payments; and
  • Limits on tax deductions for executive compensation.

Warrants


The Treasury is taking warrants from all CPP participants, though the form and terms of the warrants vary by entity type.

The Treasury will receive warrants to purchase common shares from Publicly Traded Entities 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 generally must be freely transferable. 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 the date of the Treasury’s investment. Common shares issued to the Treasury will be nonvoting.

For Nonpublic C Corporations, the Treasury will receive warrants to purchase a number of additional 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, and they will have a 10-year term. The Treasury intends to exercise the warrants immediately. The Warrant Preferred Shares have the same rights, preferences, privileges, voting rights and other terms as the Preferred Shares, except they will pay dividends at a rate of 9%, and such shares may not be redeemed until the Preferred Shares have been redeemed.

S Corporations will provide the Treasury with warrants to purchase a number of Senior Securities in an amount equal to 5% of the amount of Senior Securities purchased on the date of investment (“Warrant Senior Securities”). The exercise price for the warrants will be $.01 per note representing a Warrant Senior Security. The warrants have a 10-year term, and the Treasury intends to exercise them immediately. The Warrant Senior Securities have the same terms as the Senior Securities, except the interest on the Warrant Senior Securities will be 13.8% and the Warrant Senior Securities may not be redeemed until the Senior Securities have been redeemed.

Other Information and Considerations


Entities with applications pending should consider factors beyond the requirements of the term sheet when determining whether to accept CPP funds. In addition to the costs and restrictions of the CPP discussed above, potential participants should identify any corporate governance impediments or tasks to complete in order to comply with the requirements of the CPP. Closing costs and the availability of alternate sources of capital are also factors to consider, as well as the possibility that the government may place additional restrictions on CPP funds in the future.

The government has already begun to require information and implement requirements beyond those identified in the term sheets, such as reports on participant lending activity. In addition, based on our experience processing CPP applications, regulators may ask applicants to provide information beyond what is requested in the application, such as information confirming viability of the entity. Entities may also be asked to provide information regarding the intended use of the CPP funds.

Takeaway


The benefits and costs of obtaining CPP funds continue to fluctuate based on the changing economy, evolving restrictions placed on CPP participants, and the shifting needs and opportunities available to banking entities. Therefore, CPP applicants should continue to monitor the appropriateness of the CPP for their institutions. Fredrikson & Byron clients receive detailed updates regarding important changes that affect potential CPP participants within days after the changes are announced. These updates are available at http://www.fredlaw.com/articles/banking/index.html.