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10.16.2008 | Legal Update

The Treasury Department this week unveiled a program to provide equity capital that qualifies as Tier 1 capital directly to eligible financial institutions in an effort to encourage the extension of credit to businesses and consumers.

The Capital Purchase Program will use up to $250 billion of the $700 billion authorized under the Emergency Economic Stabilization Act of 2008 (EESA) to purchase senior preferred stock from eligible financial institutions under standardized terms published by the Treasury on October 14.  An institution that sells senior preferred stock under the program must also issue to the Treasury warrants to purchase shares of the institution’s common stock that then have an aggregate market value equal to 15% of the senior preferred stock investment.  The Treasury announced that nine large institutions have already agreed to issue preferred stock under the program for an aggregate amount of $125 billion.

Nutter Notes:  The EESA does not expressly authorize the Treasury to take an equity stake in a financial institution except where the institution sells troubled assets into the Troubled Asset Relief Program (TARP) under the EESA.  However, the EESA defines the term troubled asset to include—in addition to mortgage-related assets—any financial instrument that the Secretary of the Treasury determines (after consultation with the Federal Reserve Chairman) the purchase of which is “necessary to promote financial market stability.”  Therefore, if the Secretary determines that certain securities issued by a financial institution or a class of institutions are troubled assets, those securities may be purchased under the TARP.  Presumably this is the authority on which the Secretary relies in establishing the Capital Purchase Program.  If that is the case, EESA requires the Secretary to transmit such a written determination to the appropriate committees of Congress.

1.  Qualifying Financial Institutions

Only “Qualifying Financial Institutions” (QFIs) will be eligible to participate in the Capital Purchase Program.  The term QFI is defined to include most U.S. banks, savings associations and their holding companies, including stock banks and subsidiary stock holding companies controlled by a mutual holding company.  Any institution that is controlled by a foreign bank or company is not a QFI.

Nutter Notes:  Registration requirements and other standardized terms of the senior preferred stock and warrants suggest that QFIs must already have equity securities that are traded on a national exchange.  There are provisions in the Treasury’s standardized terms for the issuance of debt or other economic instruments, as determined by the Treasury, if a QFI is no longer listed on a national exchange, but it is not clear whether a private or closely held financial institution will be eligible to participate in the Capital Purchase Program.

2.  Timing and Availability of Funds

Investments from the Capital Purchase Program will be available to institutions that elect to participate by November 14, 2008.  The Treasury announced that it intends to fund the purchase of senior preferred stock by the end of 2008.  Treasury will determine the eligibility and allocation of investments to interested institutions after consulting with the federal banking agencies.  Interested financial institutions should contact their primary federal regulator for enrollment details.

Nutter Notes:  The Secretary’s investment authority is limited initially to $250 billion under the EESA.  If the Treasury invests all of those funds in the Capital Purchase Program, the President will need to certify to Congress that the Secretary needs additional funding to cover the purchase of mortgage-related assets under the TARP, in which case the overall limit automatically increases to $350 billion.  An additional $350 billion would be available following a written report by the President to Congress detailing the need unless Congress within 15 days by a joint resolution denies the request.

3.  Executive Compensation and Corporate Governance

Any QFI that sells preferred stock to the Treasury will be required to comply with the limitations on executive compensation and the corporate governance requirements set forth in the EESA and any guidance or regulations issued by the Secretary to carry out those requirements.  The QFI and its senior executive officers will also be required to execute a waiver releasing the Treasury from any claims they may otherwise have as a result of any modification of benefit plans and other compensation arrangements or agreements necessary to comply with the requirements of the EESA and Treasury’s guidance or regulations.  The EESA requires each selling institution to meet “appropriate standards” for executive compensation and corporate governance.  Those standards must include provisions to recover or “clawback” bonus or incentive compensation paid to any senior executive officer of the selling institution based on statements of earnings, gains or other criteria that are later proven to be materially false, as well as a prohibition against making any golden parachute payments to any senior executive officer during the period that the Secretary holds an equity or debt position in the institution. 

Nutter Notes:  The interim final rule on executive compensation requirements published by the Treasury also requires that the compensation committee of the board of directors of the QFI (or a comparable board committee) meet with the institution’s senior risk officers within 90 days after the issuance of the senior preferred stock and at least annually thereafter to ensure that incentive compensation does not encourage excessive risks that threaten the value of the institution.  The compensation committee of the board of directors of the QFI must provide certifications of that assessment.  For a QFI subject to SEC reporting requirements, the certification should be disclosed under the Compensation Discussion and Analysis in periodic reports per Rule 402(b) of the SEC’s Regulation S-K.  A private QFI should file the certification with their primary federal regulator.  The executive compensation limits will generally apply to the chief executive officer, chief financial officer, and the next three most highly compensated executive officers.

4.  Standardized Terms of Senior Preferred Stock

A QFI may sell non-voting, perpetual, senior preferred stock with a liquidation preference of at least $1,000 per share to the Treasury that complies with the following standard terms and conditions:

• Size:  The amount of senior preferred stock must be at least 1% of the QFI’s risk-weighted assets, and not more than the lesser of $25 billion and 3% of its risk-weighted assets.

• Ranking:  The senior preferred stock must be senior to common stock and pari passu (of equal rank) with existing preferred stock (other than preferred stock which, by its terms, ranks junior to other existing preferred stock).

• Dividend:  Dividends will be payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year at rate of 5% per annum until the fifth anniversary of the date of issuance, and then at a rate of 9% per annum.  Dividends will be non-cumulative for banks that are not subsidiaries of holding companies, and cumulative for all other QFIs.  The Treasury’s consent will be required for any increase in dividends on common shares for three years after the issuance of the senior preferred stock (unless the senior preferred stock has been redeemed or transferred to a third party).

Nutter Notes:  The Treasury’s senior preferred stock terms limit a QFI’s authority to declare or pay dividends on other equity securities unless all senior preferred stock dividends are fully paid.  If not, the QFI may not declare or pay dividends on common shares, junior preferred shares or preferred shares ranking pari passu with the senior preferred stock (other than dividends on a pro rata basis with the senior preferred stock).  The limitations also apply to repurchase or redemption of any common shares, junior preferred shares, or preferred shares ranking pari passu with the senior preferred stock.

• Redemption:  Senior preferred stock may not be redeemed for three years except with the proceeds of a subsequent sale by the QFI of common stock for cash or the sale of perpetual preferred stock qualifying for Tier 1 capital treatment.  Such sale must result in aggregate gross proceeds to the QFI of at least 25% of the issue price of the senior preferred stock (referred to as a “Qualified Equity Offering”).  Any redemption must be at 100% of the issue price of the senior preferred stock plus accrued and unpaid dividends and will be subject to approval by the QFI’s primary federal bank regulator.

• Voting Rights:  The senior preferred stock will be non-voting except for class voting rights on any issuance of senior equity, any amendment to the rights of the senior preferred stock, or any merger, exchange or similar transaction adversely affecting the rights of the senior preferred stock.

Nutter Notes:  The senior preferred stock will have the right to elect two directors of the QFI if dividends on the senior preferred stock are not paid in full for six dividend periods, whether or not consecutive.  The right to elect directors will terminate when dividends have been paid for four consecutive dividend periods.

• Transferability:  A QFI will be required to file a shelf registration statement covering the senior preferred stock promptly after issuance.  The QFI will be required to grant the Treasury piggyback registration rights and take any other steps reasonably requested by the Treasury to facilitate a transfer of the senior preferred stock, including registration on a national exchange.

5.  Standardized Terms of Common Stock Warrants

A QFI that sells senior preferred stock under the Capital Purchase Program must also issue warrants to the Treasury to purchase shares of the QFI’s common stock that then have an aggregate market value equal to 15% of the senior preferred stock investment.  The warrants will be exercisable for 10 years and must contain the following standard terms and conditions:

• Exercise:  The initial exercise price will be the market price for common stock calculated on a 20-trading day trailing average from the date of the senior preferred stock investment (subject to customary anti-dilution adjustments).  The warrants will be immediately exercisable when issued, though there are restrictions on the Treasury’s right to exercise or transfer more than half of the warrants before December 31, 2009, described below under “Transferability.”

Nutter Notes:  If the QFI does not have enough authorized shares of common stock to reserve for issuance on exercise of the warrants, or stockholder approval is required for issuance, the QFI will be required to hold a stockholder vote to authorize any action necessary to allow for the exercise of the warrants.  The initial exercise price of the warrants will be reduced by 15% every six months after the date of issuance, up to a maximum of 45%, until the stockholders authorize such action.

• Reduction:  The number of shares of common stock the Treasury may purchase on exercise of the warrants will be reduced by half if the QFI has received aggregate gross proceeds of at least 100% of the senior preferred stock investment from one or more Qualified Equity Offerings by December 31, 2009.

• Voting:  The Treasury will not vote any shares of common stock issued on exercise of the warrants.

• Transferability:  The Treasury may not transfer or exercise more than half of the warrants before December 31, 2009 or the date on which the QFI has received aggregate gross proceeds of at least 100% of the senior preferred stock investment from one or more Qualified Equity Offerings, whichever is earlier.  A QFI will be required to file a shelf registration statement covering the warrants and underlying common stock promptly after issuance.  The QFI will be required to grant the Treasury piggyback registration rights and take any other steps reasonably requested by the Treasury to facilitate a transfer of the warrants and underlying common stock, including registration on a national exchange.

• Substitution:  The warrants will become exchangeable for senior debt at the option of the Treasury if the QFI is no longer listed on a national exchange or the stockholders have not authorized any action necessary to allow for the exercise of the warrants within 18 months after issuance.  The Treasury may also exchange the warrants for any other debt or economic instrument as determined by the Treasury as compensation for the value of the warrants in such a case.

6.  Direct Assistance for Failing Institutions

The Treasury also announced this week that it is developing another program to provide “direct assistance” to failing institutions that are systemically significant.  Such assistance would be negotiated on a case-by-case basis and would require executive compensation standards similar to those under the Capital Purchase Program, except that golden parachute payments will be defined more strictly to prohibit any severance payments to senior executive officers.

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