U.S. Department of the Treasury Announces Terms For Private Company Preferred
Sub-S and Mutuals Still Under Review; Costs of Funds Generally 6%-7% with Issuance of Warrant Preferred; Applications Due December 8.
On November 17, 2008, the U.S. Department of the Treasury ("Treasury") announced the terms of the TARP Capital Purchase Program for privately held qualifying financial institutions ("Private QFIs"). Private QFIs do not include subchapter S corporations or mutual depository institutions at this time. Included with the announcement were a term sheet and answers to frequently asked questions. Participation in the Capital Purchase Program is voluntary. Applications to participate must be filed with the financial institution's federal banking regulators by December 8, 2008.
In general, the terms for public and Private QFIs are very similar; however, Private QFIs should be alerted to some significant differences. Unlike the public company program, Private QFIs require permission from the Treasury to increase common dividends more the 3% per year after the third year of the issuance of Preferred Stock. Private QFIs are also prohibited from entering into transactions with related persons subject to very limited exceptions.
The major difference between the public company and private company programs, however, are the terms of the Warrant Preferred. Rather than issuing warrants for common shares of the Private QFI, as is the case under the public company program, the Treasury will receive warrants exercisable for additional Warrant Preferred, which the Treasury intends to exercise immediately. The structure of the warrants increases the initial cost of funds to Private QFIs, generally, to between 6% and 7% (instead of 5%). The Warrant Preferred carry a 9% dividend rate. This structure effectively makes the cost of capital significantly higher than under the public company program. For some Private QFIs, the higher cost of funds could be a deciding factor in determining whether to participate in the Capital Purchase Program. Private QFIs that are certified "community development financial institutions" by January 15, 2009, and where the Treasury's investment is $50 million or less, will not be required to issue warrants or Warrant Preferred to the Treasury.
The following is a summary of the key elements of the Capital Purchase Program for privately held qualifying financial institutions:
PRIVATELY HELD QUALIFYING FINANCIAL INSTITUTIONS
Private QFIs include the following: (1) non-publicly traded top-tier bank holding companies or savings and loan holding companies, (2) non-publicly traded U.S. banks or U.S. savings associations organized in a stock form that are not controlled by holding companies, or (3) non-publicly traded U.S. banks or U.S. savings associations that are controlled by non-publicly traded savings and loan holding companies. Private QFIs do not include subchapter S corporations, mutual depository institutions or any institution controlled by a foreign bank or company.
PREFERRED STOCK, GENERALLY
Private QFIs may issue cumulative or, if issued by a bank with no holding company, noncumulative preferred stock ("Preferred Stock") in amounts that are not less than 1% of the Private QFI's risk-weighted assets and not more than the lesser of: (i) $25 billion and (ii) 3% of the Private QFI's risk weighted assets. The Preferred Stock is perpetual and will be senior to common stock and pari passu with existing preferred stock, other than preferred stock which ranks junior to existing preferred stock. The Preferred Stock will have a liquidation preference of $1,000 per share, although the Treasury may agree to purchase the Preferred Stock with a higher liquidation preference. The Preferred Stock will be classified as Tier 1 capital for regulatory capital purposes. The Preferred Stock will have the following additional terms:
- Dividend Rates. The Preferred Stock will pay cumulative (noncumulative if issued by a bank) dividends at 5% per year for the first five years and, thereafter, will pay dividends at a rate of 9% per year. Dividends will be paid quarterly.
- Restrictions on Redemptions. The Preferred Stock may not be redeemed for three years from the date of the Treasury's investment, subject to certain exceptions, which include redemptions with capital raised in certain types of equity offerings. After the third year, the Preferred Stock may be redeemed, in whole or in part, at the Private QFI's option. Redemptions must be at 100% of issue price, plus any accrued and unpaid dividends, and are subject to approval by the Private QFI's primary federal bank regulators.
- Restrictions on Dividends. Declaring or paying dividends on junior preferred shares, preferred shares ranking pari passu or common shares is prohibited, subject to limited exceptions. Further, the Treasury's consent is required for any increase in common dividends per share until the third anniversary of the investment. Consent will not be required if the Preferred Stock is redeemed in whole or has been transferred to third parties.
- Restrictions on Repurchases. Consent will be required for any repurchases of equity or trust preferred securities until the tenth anniversary of the Treasury's investment, except for repurchases of the Preferred Stock and repurchases of junior preferred shares or common shares in connection with any benefit plan in the ordinary course of business. After the tenth year, payment of common dividends or repurchasing of equity securities or trust preferred securities are prohibited until all equity securities of the Private QFI held by the Treasury are redeemed in whole or transferred to third parties.
- Limited Voting Rights. Preferred Stock will be non-voting, except with respect to the following: (i) authorizing or issuing shares ranking senior to the Preferred Stock, (ii) any amendments that change the rights of the Preferred or (iii) any merger, exchange or similar transaction which would adversely affect the rights of the Preferred. Dividends which are not paid in full by the Private QFI for six consecutive or non-consecutive dividend periods will entitle the Preferred Stock holders the right to elect two directors.
- Transferability. The Treasury may transfer the Preferred Stock at any time provided that the transfer would not require the Private QFI to become subject to the periodic reporting requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934.
- Restrictions on Related Party Transactions. For as long as the Treasury holds the Preferred Stock, the Private QFI must not enter into transactions with related persons (within the meaning of Item 404 under the SEC's Regulation S-K) unless the transaction (i) is on terms no less favorable to the Private QFI and its subsidiaries than could be obtained from a third party, and (ii) has been approved by the audit committee of the Private QFI or a comparable body of independent directors.
With the purchase of Preferred Stock, the Treasury will receive warrants to purchase net shares of additional Preferred Stock of the Private QFI ("Warrant Preferred"). The initial exercise price will be $0.01 per share or greater as required by the Private QFI's charter. The Warrant Preferred are immediately exercisable and the Treasury intends to immediately exercise the warrants. The terms of the Warrant Preferred include:
- Term. Ten year term.
- Liquidation Preference. Aggregate liquidation preference equal to 5% of the Preferred Stock amount on the date of investment.
- Dividend Rates. Dividends will be paid at a rate of 9% per year and may not be redeemed until all the Preferred Stock has been redeemed.
- Transferability. The Warrant Preferred will not be subject to any contractual restrictions on transfer.
- Other Rights. The same rights, preferences, privileges, voting rights, and other terms as the Preferred Stock.
EXECUTIVE COMPENSATION RESTRICTIONS
As a condition of the Treasury's investment in any Preferred Stock of a Private QFI, the Private QFI and its senior executive officers (which include the chief executive officer, chief financial officer, and the next three highest compensated executive officers) must modify or terminate all benefits plans, arrangements and agreements (including golden parachute agreements) to the extent necessary to be in compliance with, and agree to be bound by, the compensation and corporate governance standards of Section 111 of the Emergency Economic Stability Act of 2008 ("EESA"), and any guidance or regulations issued by the Secretary of the Treasury. The Private QFI and its senior executive officers must also grant the Treasury a waiver releasing the Treasury from any claims that the Private QFI and its senior executive officers may have as a result of the issuance of any regulations that modify the terms of the benefits plans, arrangements and agreements.
The executive compensation and corporate governance standards of Section 111 of the EESA that must be adopted by a Private QFI include the following:
- Discouragement of "Unnecessary and Excessive" Risks. The Private QFI must ensure that incentive compensation for its senior executive officers does not "encourage unnecessary and excessive risks that threaten the value of the financial institution."
- Reduced Executive Compensation Tax Deduction Limit. The Private QFI must limit its deductions of executive compensation for each of its five senior executive officers, pursuant to Internal Revenue Code Section 162(m), to $500,000, based on compensation earned in a year during which the Private QFI participates in the program.
- Required "Clawback". Performance pay must be subject to repayment if it is based on information that is later determined to be based on any materially inaccurate financial statements or performance metric criteria.
- Golden Parachute Payments Prohibited. The Private QFI is prohibited from making any excess golden parachute payment based on Internal Revenue Code Section 280G triggered by involuntary termination without cause, or bankruptcy, insolvency or receivership of the Private QFI.
Frost Brown Todd will continue to monitor developments related to this advisory and any upcoming guidance on S corporations and mutual depository institutions.
For more information or assistance, please contact one of the members of our Financial Institutions practice listed below:
R. James Straus (502-568-0221; email@example.com)
Nathan L. Berger (502-779-8168; firstname.lastname@example.org)
Dawn R. Franklin (502-779-8500; email@example.com)