On October 14, 2008, under the authority of the Emergency Economic Stabilization Act of 2008 ("EESA"), the U.S. Treasury announced that it would make available $250 billion of capital to U.S. financial institutions. Nine large financial organizations have already indicated their intention to subscribe to the facility in an aggregate amount of $125 billion. Under the program, the government will purchase up to $250 billion of senior preferred shares and common stock warrants on standardized terms as described in a term sheet published and released by the government along with the October 14 announcement. The program will be available to Qualifying Financial Institutions ("QFI") that include U.S. controlled banks, savings associations, and certain bank and savings and loan holding companies engaged only in financial activities that elect to participate before 5:00 pm (EDT) on November 14, 2008. On Monday October 20, 2008, the Treasury announced the procedures for applying for the program. The application must be submitted to the QFI's primary lender. The program is not a "first come, first served" program. The Treasury will determine eligibility and allocations after consultation with the QFI's primary federal regulator. A QFI that desires to participate must sell a minimum of senior preferred shares equal to 1 percent of its risk-weighted assets. The maximum amount that a financial institution may sell is the lesser of $25 billion or 3 percent of risk-weighted assets.
The senior preferred will qualify as Tier 1 capital and will rank senior to common stock and "pari passu" (on the same level in the capital structure) with existing preferred shares, other than preferred shares, which, by their terms, are junior to any other existing preferred shares. The Treasury has included specific incentives for participating QFI's to raise new capital to redeem the senior preferred.
Senior Preferred
The senior preferred will have the following material terms.
Term. The senior preferred will be perpetual.
Dividends. The senior preferred will pay a quarterly dividends at the rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum thereafter. For holding companies the dividends will be cumulative; for stand-alone banks the dividends will be non-cumulative. If dividends are not paid on the senior preferred for six quarters (whether or not consecutive) the government will have the right to elect two directors.
Non-Voting. The preferred shares will be non-voting, other than special voting rights for matters that affect the rights of the preferred. It should be noted that under some state corporate codes, holders of preferred stock are given class voting rights on certain corporate transactions such as a merger of the corporation as a matter of state law regardless of terms of the preferred stock.
Call Protection; Optional Redemption. The senior preferred may not be redeemed for three years, except with the proceeds from a "qualifying equity offering" of any Tier 1 capital (perpetual preferred or common stock) which results in gross proceeds of not less than 25 percent of the issue price of the senior preferred. After that time the senior preferred may be redeemed at any time (in whole or part) at the option of the financial institution for the issue price without a premium plus accrued and unpaid dividends.
Dividend Restrictions. While the senior preferred is outstanding, the financial institution may not increase common stock dividends without the prior approval of Treasury. Dividend payments on common, junior preferred or pari passu preferred will be prohibited unless all accrued and unpaid dividends on the senior preferred have been paid.
Warrants
As part of its investment in the senior preferred the Treasury will receive warrants to purchase a number of shares of common stock of the issuer having an aggregate value of 15 percent of the senior preferred. The warrants will be subject to the following terms:
Term. The warrants will have a 10-year term.
Exercise Price. The warrant exercise price will be the market price of the participating institution's common stock at the time of issuance, calculated on a 20-trading day trailing average. For smaller financial institutions there may not be a "trading market" with daily reported transactions.
Exercise of the Warrants. The warrants will be immediately exercisable, in whole or part, from the date of issuance the expiration, except that the Treasury will be permitted to exercise only one-half of the warrants before the earlier of a qualified equity offering that raises 100% of the issue price of the senior preferred or December 31, 2009.
Non-Voting. The Treasury will agree not to vote the common shares.
Warrant Reduction. If the financial institution raises at least 100 percent of the issue price of the senior preferred through a qualified offering of common or perpetual preferred by December 31, 2009, the number of shares underling the warrants will be reduced by 50 percent.
Registration of Preferred Shares and Warrants
The terms of the Treasury financing will require the financial institutions to register the senior preferred stock, warrants and common stock issuable upon exercise of the warrants with the Securities and Exchange Commission pursuant to the Securities Act of 1933 so that the securities may be transferred by the government at anytime. The securities also must be listed for trading on any exchange the financial institution's common stock trades. It is thus possible that the preferred stock and warrants will trade separately from the common stock.
Executive Compensation Issues
Participating financial institutions will be required to adopt certain executive compensation standards as a condition to the financing. The standards will apply to the chief executive officer, the chief financial officer and, excluding these two officers, the three highest paid executives. These standards will include: 1) ensuring that incentive compensation for covered executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; 2) requiring "clawback" policies of any bonus or incentive compensation paid to covered executives based on financial statements that are found to be materially inaccurate; 3) restrictions on the payment of golden parachutes to covered executives; and 4) restrictions on deductions for tax purposes on compensation in excess of $500,000 for each covered executive officer.
Perspective
The government's program is structured similar to a "private investment in a public company" (socalled PIPE) transaction. The issuance of the preferred shares and warrants will be purchased in a private sale without registration with the SEC on the condition that the issuer files a resale registration statement following the closing of the private sale. This type of transaction is familiar to many public companies. This allows for an expedited funding without SEC delay. The securities will become freely tradable once the resale registration statement is declared effective by the SEC. Many financial institutions will already have a "shelf" registration on file with the SEC which will permit an even easier method to register the securities by way of filing a prospectus supplement to the registration statement. Financial institutions will want to inquire as to how long the registration statement must be maintained since SEC rules permit privately placed securities to be freely traded as early as 6 months after issuance, subject to certain conditions, and after 12 months with no conditions.
Although most of the documentation will be standardized, each financial institution will have some unique issues that will have to be addressed in the final agreements.
The Treasury terms do not address how the financing structure will be modified for those financial institutions who are not required to register securities with SEC because of exemptions for the Securities Act of 1933. For example, stand-alone banks without a holding company structure generally may issue freely tradable securities without SEC registration in reliance on statutory exemptions under the Securities Act.
Because the program still needs to be flushed out with further regulations and the deal documents still must be developed, participating institutions would be advised to work with legal counsel experienced in these types of corporate financing transactions not only in monitoring the fast paced developments, but to also be in position to close the transactions authorized under this new legislation before the end of year.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
