Posts filed under ‘Financial Institutions’
Treasury Extends the TARP to Cover S-Corporations
Yesterday, the United States Treasury issued the much-anticipated Term Sheet setting forth the terms for financial institutions operating under Subchapter S of the Internal Revenue Code (S-Corps) to participate in the TARP Capital Purchase Program (CPP). The application deadline is February 13, 2009. To review the Term Sheet in its entirety, click here. To review the Treasury’s Frequently Asked Questions about the Term Sheet, click here. Here’s an overview of the Term Sheet:
- Security Type: Unlike previous CPP transactions, S-Corps will not sell preferred stock to Treasury. Instead, participating S-Corps will issue subordinated debentures, referred to in the Term Sheet as “Senior Securities.”
- Amount: A participating financial institution will issue Senior Securities in an aggregate principal amount that equals at least 1% of the institution’s risk-weighted assets and does not exceed 3% of risk-weighted assets or $25 billion, whichever is less.
- Key Terms: Each debenture representing a Senior Security will be issued in the principal amount of $1000, will require quarterly interest payments at a rate of 7.7% per annum for the first five years the securities are outstanding and 13.8% thereafter and will carry a maturity date of 30 years. (These interest rates are higher than the dividend rates payable under previous CPP transactions. Treasury increased the rate for S-Corps to offset the fact that interest payments are tax-deductible but dividends are not.)
- Capital Treatment: The Senior Securities will be treated as Tier 1 capital for holding companies and Tier 2 capital for banks or other associations.
- Interest Deferral: Holding companies may defer interest payments on the Senior Securities for up to 20 quarters. Unpaid interest will accrue and compound during any deferral period.
- Dividend Restrictions: No dividends on shares of equity or trust preferred securities may be paid while an interest deferral is in effect. For the first three years of participation, Treasury must consent to any increase in the participant’s regularly paid common dividends. After the third year, Treasury must consent to any dividend increase that exceeds an amount equal to 103% of the prior year’s dividend. However, Treasury’s consent is not required for any dividend increase if the increase is proportionate to the increase in the financial institution’s income, and the increased dividends are distributed to shareholders to pay increased income tax liabilities.
- Voting: The Senior Securities will be non-voting, except that they will have class voting rights on (1) the issuance of equity securities purporting to rank senior to the Senior Securities, (2) amendments to the rights of the Senior Securities, and (3) any merger, exchange or similar transaction that would adversely affect the Senior Securities’ rights. Further, if interest is not paid in full for six interest periods, consecutive or non-consecutive, Treasury will be able to elect two directors until all interest payments are current.
- Executive Compensation: The senior executive officers of S-Corps participating in CPP will be subject to the executive compensation provisions in EESA and its implementing regulations.
- Affiliate Transactions: For as long as the Treasury holds its Senior Securities, a financial institution may not enter into a transaction with a related person unless the transaction is on terms no less favorable than could be obtained from an unaffiliated third party.
Just like other federal programs aimed at alleviating stress in the financial sector during the current economic downturn, the S-Corp CPP has advantages and disadvantages. We strongly urge all S-Corps to weigh those benefits and costs in deciding whether to apply for this particular program before the February 13th application deadline.
Application Process Delayed For Treasury’s Capital Purchase Program
The Treasury Department, on October 31, announced that the November 14, 2008 application deadline and public term sheet for participation in the Capital Purchase Program applies solely to eligible publicly traded financial institutions. The Treasury will post an application form and term sheet for privately held eligible financial institutions at a later date and establish a reasonable deadline for privately held institutions to apply.
As always, we will keep you informed of the new deadlines. Please contact us if you have any questions.
Executive Compensation —Treasury Tightens Financial Institutions’ Purse Strings
Overview. The U.S. Department of the Treasury (Treasury) has issued an interim final rule (New Compensation Restriction Rules) implementing the executive compensation provisions of the Emergency Economic Stabilization Act of 2008 (EESA). The New Compensation Restriction Rules apply to the senior executive officers of any financial institution participating in any part of the Treasury’s Troubled Assets Relief Program (TARP), including, the Capital Purchase Program (CPP), the Program for Systemically Significant Failing Institutions (PSSFI) and the Troubled Asset Auction Program (TAAP). Although the extent of the Compensation Rules’ impact will depend upon the program in which a particular financial institution chooses to participate, most institutions (even private ones) will be required to comply with one or more of the following rules:
- Ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks;
- Recover any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that prove to be materially inaccurate;
- Refuse to make any golden parachute payment to a senior executive officer during the period that the Secretary holds an equity or debt position in the institution;
- Forego federal income tax deductions on executive compensation exceeding $500,000 in a given tax year. Note: not a restriction on compensation levels, but on deductibility; and
- Senior executives covered by the New Compensation Restriction Rules include the chief executive officer, chief financial officer and the three other most highly compensated executive officers (SEOs).
When do these new rules apply? The applicability of the New Compensation Restriction Rules depends upon several factors, including the value of the assets sold by the institution to the Treasury and the method by which the Treasury acquires those assets (directly or via auction). Consider the following:
- The Compensation Restriction Rules apply to every financial institution along with its control group parent or subsidiaries (Subject Entity) that (a) participates in CPP, (b) sells more than $300 million of assets via the TAAP or (c) becomes part of the PSSFI.
- For participants in the CPP, the New Compensation Restriction Rules apply only during the time period that the Treasury holds an equity or debt position in the financial institution. For participants in the TAAP, the New Compensation Restriction Rules apply at least through December 31, 2009 and possibly through October 3, 2010, depending on whether Treasury extends the program.
- The New Compensation Restriction Rules apply only to SEOs. To implement this requirement, the New Compensation Restriction Rules look to Item 402 of Regulation S-K, applied under federal securities laws in connection with public offerings and public company periodic reporting. The Item 402-based determination of SEOs applies whether the institution is public or private.
Item 402 states that executive officers (other than the CEO or CFO) must make at least $100,000 and the determination as to which executive officers are the most highly compensated shall be made by reference to total compensation for the last completed fiscal year. However, the New Compensation Restriction Rules require Subject Entities to use “best efforts” to determine the three most highly compensated executive officers prior to having year-end compensation data for the current year. Also, Item 402 states that executive officers may include one or more executive officers or other employees of subsidiaries. Under limited circumstances, a Subject Entity may exclude an individual, other than its CEO or CFO, who is otherwise one of the most highly compensated executive officers, due to the payment of amounts of cash compensation relating to overseas assignments attributed predominantly to such assignments.
Restrictions By Specific TARP Program. As noted above, the effect that the New Compensation Restriction Rules will have on a given financial institution will depend upon which TARP program the institution chooses. The following paragraphs explain in greater detail the compensation restrictions associated with a given TARP program.
- Capital Purchase Program – This program allows the Secretary to purchase assets directly from financial institutions in exchange for a meaningful debt or equity position in the institution. The New Compensation Restriction Rules place several compliance requirements on financial institutions participating in the CPP.
First, the institution’s compensation committee, in conjunction with the institution’s senior risk officers, must ensure that SEO compensation packages do not prescribe incentive compensation that promotes unnecessary and excessive risks. The first such review must be completed within 90 days of the institution’s initial participation in the CPP, and a similar review must occur annually (but only while the Secretary holds a debt or equity interest in the institution pursuant to CPP). After these reviews, the compensation committee must certify that the reviews have been completed. Note the rules provide no guidance, other than consultation with risk management officers, as to what constitutes risk-promoting compensation. And, although the rules require the compensation committee to certify that SEO contracts comply with the prohibition on risky compensation pay, the certification will not be provided until after the Treasury has purchased troubled assets from the Subject Entity. The New Compensation Restriction Rules are not clear on what would happen if an existing contract did not comply with the Secretary’s guidelines.
Second, any financial institution participating in the CPP must require SEOs to repay any bonus or incentive compensation previously received if such compensation was based on statements of earnings, gains or other criteria that prove to be materially inaccurate. Note, although similar in many respects to Section 304 of Sarbanes-Oxley, this provision is in reality much broader. This provision applies to both public and private institutions, is not triggered exclusively by an accounting restatement, has an unlimited recovery period and covers not only material inaccuracies in financial reporting, but also material inaccuracies relating to other performance metrics used to award bonuses and incentive compensation.
Third, a financial institution cannot make any golden parachute payments to any SEOs while the Secretary holds an equity or debt position acquired under the CPP. For purposes of this rule, the term “golden parachute” payment refers to any compensation, other than a payment under a qualified retirement plan, with an aggregate present value that equals or exceeds 300% of the employee’s base salary. While that definition is similar to the term “excess parachute” payment set forth in § 280G of the Internal Revenue Code, “golden parachute” payments subject to EESA include all payments triggered by an applicable severance from employment, regardless of whether there has been a change in control of the financial institution, and encompass most any compensation paid on account of an SEO’s involuntary termination from employment, including terminations associated with the institution’s bankruptcy, insolvency or receivership.
Fourth, the financial institution must agree to forego any federal income tax deduction on the compensation in excess of $500,000 paid to any SEO.
- Programs for Systemically Significant Failing Institutions – Under this program, the Treasury provides direct assistance to certain failing financial institutions on terms negotiated on a case-by-case basis. These standards are similar in all respects to the New Compensation Restriction Rules applicable to the CPP, except that the definition of “golden parachute payment” is defined even more broadly. Like the CPP program discussed above, a financial institution participating in the PSSFI must prohibit any golden parachute payment to a SEO while the Treasury holds a meaningful equity or debt position in the institution. But unlike the CPP, for purposes of PSSFI, a “golden parachute payment” is defined as any compensatory payment to an SEO on account of severance from employment (i.e., not just payments in excess of 300% of the SEO’s base amount).
- Troubled Asset Auction Program – Under this program, the Treasury purchases troubled assets from a financial institution through an auction format. As prescribed by EESA, any financial institution that sells more than $300 million of troubled assets to the Treasury via auction would be prohibited from entering into new executive employment contracts that would provide a golden parachute payment to an SEO in the event of the SEO’s involuntary termination, or in connection with the financial institution’s bankruptcy filing, insolvency or receivership. The employment agreements subject to this rule will be considered “new” agreements if entered into on or after the date the financial institution has sold at least $300 million in troubled assets under TARP, provided that some of the asset sales were conducted through TAAP. An employment agreement that is renewed or materially modified after such date is also considered a “new” arrangement for this purpose. In addition, EESA precludes any financial institution from receiving any federal income tax deduction for any compensation in excess of $500,000 paid to an SEO.
Recent Activity Impacting Financial Institutions
Kansas Bankers Surety Exits Private Deposit Insurance Business
Kansas Bankers Surety Co., a subsidiary of Berkshire Hathaway based in Topeka, Kansas, and one of the largest private bank deposit insurance providers in the Midwest, recently announced that, effective immediately, it will no longer provide banks with deposit guaranty bonds to insure deposits in excess of the FDIC’s $100,000 limit. The company made the decision to exit the private deposit insurance business, in part, because of recent bank failures and the company’s inability to buy reinsurance for the product. The company indicated that within the next few months they will begin sending notices to depositors that their existing policies will be cancelled after 90 days from the date of the notice. Your financial institution should explore the various alternatives to Kansas Bankers Surety’s product. Those alternatives include:
- CDARS®. If your bank is a member of Certificate of Deposit Account Registry Service®, which is offered by the Promontory Interfinancial Network, LLC, then your bank can offer depositors up to $50 million in FDIC deposit insurance by placing deposited funds into various certificates of deposit, in increments of $100,000 or less, issued by other banks in the CDARS® network. This alternative may not be available to all banks.
- Repurchase Agreements. Your bank can enter into repurchase agreements with large depositors whereby the bank agrees to sell government securities to a depositor and, subsequently, repurchase the securities from the depositor at a specified price and a specified time (either the next business day or at the expiration of a stated term). The depositor benefits from this arrangement because the depositor owns a government-backed security, rather than a partially uninsured bank account. Banks must carefully follow government securities regulations to properly transfer legal ownership of the security to the depositor in order to provide the depositor with protection if the bank fails. Further, failure to follow those regulations may subject the bank to regulatory criticism.
- Collateralized Deposits – Public Funds. In most states, banks are required to “collateralize” deposits of public funds, such as those of the state, counties, municipalities and school districts. State law varies on the types of collateral banks must pledge. While banks may be required to pledge collateral to secure deposits of public funds, banks are generally prohibited from pledging collateral to secure deposits of non-public funds.
- Private Deposit Insurance – Other Vendors. Banks may continue to purchase private excess deposit insurance from any of the remaining providers in the market.
Government Bailout Felt by the Shareholders of Fannie Mae and Freddie Mac
Banks across the country will immediately feel the consequences of the recent government bailout of Fannie Mae and Freddie Mac. Banks that own preferred stock in those entities will be forced to write off much of the value of those shares further aggravating the capital problems facing many banks. Of significance, the takeover suspends dividend payments in respect of preferred shares. The suspension of dividends has prompted a drop in value of the shares in the two companies of greater than 80 percent. Those losses may result in “other-than-temporary-impairment” charges, which would have a negative impact on regulatory capital.
The Federal Reserve Board and other federal regulators have responded to the potential impact, stating in a recent press release that they “are prepared to work with these institutions to develop capital-restoration plans.” Treasury Secretary Henry Paulsen has explained that if any bank faces losses that will place them below the government designation of a “well-capitalized” institution they should contact their primary federal regulator. Initial indications are that only a handful of banks should be affected to this extent but the cumulative impact of the write-downs will reverberate throughout the banking system.
What this means for your financial institution:
- You should determine the extent of your holdings with Fannie Mae and Freddie Mac and determine the potential impairment charge as a result of those holdings.
- Banks with substantial holdings of these shares may need to address the losses by seeking additional capital, restructuring their balance sheet, suspending dividend payments or identifying possible merger opportunities.
September 11, 2008 at 6:11 pm stinsonbanking Leave a comment
