On Oct. 14, 2008, the U.S. Department of Treasury announced the Troubled Asset Relief Program, or TARP Program, which is one of several recent government initiatives to improve the strength of financial institutions and enhance market liquidity.1 Under the TARP Program, the Treasury will purchase up to $250 billion in Senior Preferred stock on standardized terms more fully described in the TARP Program's term sheet.2 This bulletin will briefly summarize the major aspects of the TARP Program.
Qualifying Financial Institutions
The TARP Program is generally available to the following “Qualified Financial Institutions”: (i) U.S. bank or savings associations not controlled by a bank holding company (BHC) or savings and loan holding company (SLHC) and; (ii) any U.S. BHC, or any U.S. SLHC that engages in activities that are financial in nature or complementary to a financial activity and does not pose a risk to the safety and soundness of depository institutions or the financial system generally3 and any U.S. bank or U.S. savings association controlled by such qualifying U.S. BHC or SLHC except that Qualified Financial Institutions will not include any BHC, SLHC, bank or savings association controlled by a foreign bank or company.
Such institutions will only be qualified to participate if they elect to participate before 5 p.m. Eastern Daylight Time on Nov. 14, 2008. The Treasury will then determine the eligibility and allocation for Qualified Financial Institutions after consultation with the appropriate federal banking agency.
Corporate governance requirements for participating institutions
Institutions participating in the TARP Program will be required to adopt the Treasury's standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Program. These standards generally apply to the chief executive officer, chief financial officer, and the next three most highly compensated executive officers.
Participating institutions must meet certain standards, including: (i) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (ii) required 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; (iii) prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and (iv) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. Treasury has issued interim final rules for these executive compensation standards.
So long as any Senior Preferred stock is outstanding, no dividends may be declared or paid on junior preferred shares, preferred share ranking pari passu with the Senior Preferred stock, or common shares, and no such shares may be redeemed unless all accrued and unpaid dividends for all past dividend periods on cumulative Senior Preferred stock are fully paid, or in the case of non-cumulative Senior Preferred stock, the full dividend for the latest complete dividend period has been declared in full.
In addition, the Treasury's consent will be required for any increase in dividends on common stock or any share repurchases until the third anniversary of the issuance of the Senior Preferred stock, unless all such Senior Preferred stock is redeemed or transferred prior to such date.
Terms of the Senior Preferred
The Treasury will be purchasing Senior Preferred stock from Qualifying Financial Institutions. If a Qualified Financial Institution does not currently have preferred stock authorized for issuance under its governing documents, the Treasury has indicated that such institution will have 30 days from Nov. 14, 2008, to obtain the necessary board and shareholder approval in order to authorize the issuance of preferred stock.
Each qualified institution may issue an amount of Senior Preferred stock equal to not less than 1 percent of its risk-weighted assets and not more than the lesser of $25 billion and 3 percent of its risk-weighted assets. The Senior Preferred stock will have a liquidation preferred of $1,000 per share, and will be senior to common stock and pari passu with existing preferred shares, other than preferred shares which by their terms rank junior to any existing preferred shares, shall not be subject to any contractual restrictions on transfer and shall be non-voting other than certain class voting rights.
Cumulative dividends (non cumulative in the case of Senior Preferred stock issued by banks which are not subsidiaries of holding companies) will be payable on the Senior Preferred stock at a rate of 5 percent per annum until the fifth anniversary of the issuance of the Senior Preferred stock and at a rate of 9 percent per annum thereafter.
The Senior Preferred stock may not be redeemed for a period for three years from the date of issuance, except with the proceeds from the sale by the qualified institution of Tier 1 qualifying perpetual preferred stock or common stock for cash. All redemptions of the Senior Preferred stock shall be at 100 percent of its issue price plus, in the case of cumulative Senior Preferred stock, any accrued and unpaid dividends, and in the case of non-cumulative Senior Preferred stock, accrued and unpaid dividends for the then current dividend period. Any redemption of the Senior Preferred stock shall be subject to the approval of the qualified institution primary federal bank regulator.
In addition to the Senior Preferred stock, the Treasury will receive warrants to purchase a number of shares of common stock having an aggregate market price equal to 15 percent of the Senior Preferred stock amount on the date of the investment, subject to a 15 percent reduction on each sixth-month anniversary, for a maximum reduction of 45 percent.
The warrants will have a 10-year term, and shall be immediately exercisable. The Treasury will agree not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrants. In addition, the warrants will not be subject to any contractual restrictions on transfer.
In the event the qualified institution does not have sufficient available authorized shares of common stock to reserve for issuance upon exercise of the warrants or stockholder approval is required for such issuance under applicable stock exchange rules, the qualified institution must call a meeting of its stockholders as soon as practicable after the issuance of the warrants to increase the number of authorized shares of common stock and to comply with such exchange rules as necessary to allow the exercise of the warrants into common stock.
The term sheet issued by the Treasury is similar to a term sheet for a private transaction containing ambiguities and open items. An important question is whether companies that are not public or that are ineligible for shelf registration statements can participate, and if so, how the terms of the TARP Program will be modified. In addition, because the Senior Preferred stock will qualify as Tier 1 capital, it is unclear whether this treatment will result in existing restricted core capital elements currently on the balance sheet as Tier 1 capital to become Tier 2 capital. Items left open and other ambiguities in the term sheet will likely be resolved in the coming weeks.
Qualifying Financial Institutions will have until Nov. 14, 2008, at 5 p.m. Eastern Standard Time to apply for participation in the TARP Program. Qualifying Financial Institutions will be required to adopt the Treasury's standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Program. In addition, participation in the TARP Program will result in restrictions on dividends, stock repurchases and redemptions. Given the number of open items and ambiguities, we expect there to be additional guidance on the TARP Program in the weeks to come.
1 Other major government actions include the so-called “Bailout Bill” signed into law by President Bush on Oct. 3, 2008 (the Emergency Economic Stabilization Act of 2008, H.R. 1424, 110 th Cong. 2 nd Ses. (2008)), which created the Troubled Assets Relief Program, or TARP, the Federal Deposit Insurance Company's Temporary Liquidity Guaranty Program.
2 A copy of the publicly available term sheet is available at http://www.treasury.gov/press-center/press-releases/Documents/document5hp1207.pdf
3 12 U.S.C. §1843(k)