According to the President’s proposal, which is part of the White House’s “Financial Stability Plan,” the program would target small business lending, but would also offer a mechanism for banks with less than $1 billion in assets to access capital with an annual dividend rate of 3%.  The announcement is short on specifics, but here are the basics:

(1) Banks will receive capital in an amount equaling up to 2% of risk-weighted assets; 

(2) The annual dividends on the capital will equal 3% for the first five years and 9% thereafter; and 

(3) Banks seeking to participate in the program will submit a “small business lending plan” in which the bank explains how additional capital will help increase its lending to small businesses.  (Banks approved for the program that elect to participate will also be required to follow up with quarterly reports detailing small business activities).

Over the next few weeks, Treasury will work with community banks and the small business community to hammer out the program’s specifics.  Notably, the release contemplates that banks already participating in the capital purchase program will be able to replace existing capital, which carries a 5% dividend (7.7% for S-Corps), with investments under the new program.   

 The President also announced support for legislation that would increase the size of key Small Business Administration (SBA) loans. The aim of the increase would (supposedly) allow the SBA to ensure that more small businesses can get access to credit.

 The first prong of the proposed legislation would increase the Maximum 7(a) loan from $2 million to $5 million, providing greater access to capital that businesses could use to boost working capital as well as purchase machinery equipment and real estate.  

The second prong of the proposed legislation would increase the maximum 504 project loan from $2 million to $5 million for standard borrowers (supporting a total project of $12.5 million) and from $4 million to $5.5 million for manufacturers (supporting a total project of $13.75 million), thereby increasing the qualifying borrowers’ ability to undertake larger projects.

And the third prong of the proposed legislation would increase the maximum loan size of the SBA microloan programs from $35,000 to $50,000.

Some of the IFR’s most important provisions include the following: 

• Limitations on the amounts and types of bonuses payable to senior executive officers and other highly compensated employees.
• A ban on golden parachute payments—a term that reaches much farther than most people think, including almost any type of compensation received upon a covered employee’s departure from the institution.
• A “clawback” provision that requires an institution to recover any bonus, retention award or incentive compensation paid to a covered employee if the bonus, retention award or incentive compensation was paid in reliance on inaccurate financial information.   
• Several corporate governance and board certification requirements, including a requirement for perquisite disclosures and for implementing luxury expense controls.       
• A requirement for all TARP participants to provide shareholders with an annual, non-binding vote on the compensation of the institution’s executives.   
• An affirmation that the rule’s restrictions will not apply to institutions receiving indirect financial assistance from UST, such as institutions receiving loans from the Term Asset Loan Facility.

If your institution is currently participating in any TARP program, you are required to comply with these rules. The following initial steps should help:

• Identify which of your employees will be subject to which restrictions.  The number of employees covered by a given restriction varies depending on the type of restriction and the amount of Capital Purchase Program funding the institution has received.
• Review your institution’s employment and other compensation-based agreements, especially severance provisions, to verify that they comply with the IFR.  
• Designate appropriate board committees to confer with the institution’s senior risk officers to identify compensation policies that may encourage unnecessary risk taking.

Restrictions on Golden Parachute Payments. ARRA bans any “golden parachute payment” to a TARP participant’s senior executive officers or any of the institution’s next five most highly-compensated employees for the entire period in which Treasury holds the institution’s preferred shares.  ARRA defines “golden parachute payment” broadly, covering any payment for departure from an institution for any reason, except for payments for services performed or benefits accrued.

This provision clearly targets the handsome severance packages received by chief executives at large, failing financial institutions.  Unfortunately, the law does not distinguish between such packages and standard retirement packages received by most workers in the broader economy.  Hopefully, in his rules implementing this provision, the Secretary of the Treasury will provide for such a distinction in his interpretation of the exception for “services performed or benefits accrued.”

Restrictions on Incentive Compensation.  Employees subject to ARRA’s incentive compensation restrictions will be banned from receiving or accruing any bonus, retention award or incentive compensation, other than long-term restricted stock (in an amount that does not exceed 1/3 of the executive’s total annual compensation and does not fully vest until the government is repaid) for as long as the U.S. Treasury holds preferred shares of his or her employer. 

Employees Subject to the Incentive Compensation Restrictions.  The applicability of ARRA’s incentive compensation restrictions is determined by a sliding-scale approach, with the number of covered employees within a given institution increasing proportionately with the dollar amount of Treasury’s TARP investment in that institution.

• For institutions receiving less than $25 million under TARP, the compensation restrictions apply only to the most highly-compensated employee.
• For institutions receiving between $25 million and $250 million under TARP, the compensation restrictions apply to the five most highly-compensated employees, and possibly more if the Treasury Secretary deems it appropriate.
• For institutions receiving between $250 million and $500 million under TARP, the compensation restrictions apply to senior executive officers and at least the ten next most highly-compensated employees.
• For institutions receiving more than $500 million under TARP, the compensation restrictions apply to senior executive officers and at least the 20 next most highly-compensated employees.

ARRA’s restrictions on bonuses do not affect the payment of a bonus required to be paid pursuant to a written employment contract executed on or before February 11, 2009. 

Additional Corporate Governance Provisions.  ARRA adds additional certification and corporate governance requirements.  For as long as the Treasury owns a financial institution’s preferred shares, the institution must:

• Adopt a company policy on “excessive or luxury expenditures” that prohibits excessive expenditures on entertainment, office and facility renovations, aviation or other transportation services and other activities that are not reasonable expenses incurred in the normal course of business;
• Recover any bonus, retention award or incentive compensation paid to a senior executive officer and any of the next 20 most highly-compensated employees based on statements of earnings, revenues, gains, or other criteria that are later found to be materially inaccurate, and implement the procedures;
• Establish an independent compensation committee of the board of directors to meet at least twice a year to evaluate the risks posed by the institution’s compensation plans (this review can be conducted by the board of directors of private institutions receiving less than $25 million);
• Submit annual certifications, signed by the institutions chief executive officer and chief financial officer, affirming the institution’s compliance with the additional executive compensation restrictions;  and
• Ban compensation plans that would encourage earnings manipulation in order to increase the compensation of any employee.

Non-Binding Shareholders’ Resolutions.  Any financial institution receiving TARP funding must provide for a non-binding shareholder vote on the institution’s executive compensation packages.  ARRA does not create any additional fiduciary duties that would require the institution’s board of directors to honor the result of the shareholders’ non-binding vote.

Elimination of Redemption Restrictions.  ARRA allows financial institutions that have already issued preferred shares to redeem any preferred shares issued to the Treasury at any time, provided that the institution consults with its primary federal regulator before effecting the redemption.  This provision eliminates the three-year ban on redeeming TARP preferred shares from sources other than a subsequent private offering. 

Unresolved Issues.  Because these additional restrictions were added to ARRA near the end of the legislative process, their full impact has not been analyzed.  At first glance, it appears that the new restrictions will encourage financial institutions to move away from incentive-based compensation and to increase the guaranteed base salary of star performers and covered executive officers.  Moreover, it is unclear whether these restrictions will supersede or simply compliment the additional executive compensation restrictions issued earlier this year by the Secretary of the Treasury.  However, you can rest assured that the attorneys at Stinson Morrison Hecker LLP will continue to monitor these questions and follow future developments.
 
These latest executive compensation restrictions represent but a small sample of today’s constantly-evolving regulatory environment.  While many of these restrictions may seem like an unnecessary burden, the TARP program has attracted many participants and offers an efficient way to protect your institution’s capital reserves.  If your financial institution would like additional guidance on TARP or any other government liquidity program, such as the FDIC’s debt guarantee program, we have the requisite knowledge and expertise to help navigate your institution through the choppy waters of today’s marketplace.

Here is a quick overview of how the CPP works for S-Corps:

• 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.”
• 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.)
• 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.
• 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.Review the S-Corp Term Sheet in its entirety.

Review the Treasury’s Frequently Asked Questions about the Term Sheet.

Because Treasury will be issuing debt instead of equity under this program, many S-Corps have questions about the true costs of participating. Here is an estimate of the effective cost of this debt for the first five years, assuming repayment at the end of that period:

Material changes are as follows:

• Compliance and Certification. Each CEO of any institution receiving government bailout funds must certify that the institution has strictly complied with statutory, Treasury, and contractual executive compensation restrictions. Each compensation committee must also provide an explanation of how compensation arrangements do not encourage excessive and unnecessary risk.
• Institutions Receiving “Exceptional Assistance.” Institutions receiving “exceptional assistance” are now retroactively subject to the following additional restrictions:
  • $500,000 cap on each senior executive’s total compensation, instead of merely a tax deduction limit;
  • The only other allowed compensation for senior executives is restricted stock or similar long term incentive plans which limit vesting until after: (a) full repayment to the government or (b) a waiting period taking into account repayment and the interests of taxpayers;
  • Executive compensation structure and strategy must be fully disclosed and is subject to non-binding “say on pay” shareholder resolutions;
  • Now mandatory clawback of bonuses includes top 25 senior executives (rather than top five) who knowingly participated in providing inaccurate (a) information relating to financial statements or (b) performance metrics used to calculate their own incentive pay;
  • Golden parachute ban applies to the top 10 senior executives (rather than top five) and the next 25 executives cannot receive severance of more than one year’s compensation; and
  • The Board must adopt a company-wide policy on luxury expenditures, such as aviation services, entertainment and holiday parties, or conferences, and require certification by the CEO for expenditures that may be viewed as excessive or luxury.
• Proposed Restrictions for Participants in Generally Available Capital Access Programs. Additionally, the Treasury intends to issue new restrictions for institutions participating in “generally available capital access programs.” The proposed changes, which will not apply retroactively to existing investments or programs already announced, are similar to those in effect for institutions receiving “exceptional assistance.”
• Long-Term Regulatory Reform: Compensation Strategies Aligned with Proper Risk Management and Long-Term Value and Growth. Finally, the Treasury is reviewing measures to move regulations beyond those that regulate compensation strategies related only to top executives to regulations focused on how company-wide compensation strategies encourage excessive risk-taking.
• Exceptional Assistance Versus Generally Available Capital Access Programs
  • Institutions that participate in “exceptional assistance” programs are those that need more assistance than the general programs provide. Some examples of these institutions are AIG, Bank of America and Citigroup.
  • Institutions that participate in “generally available capital access programs” are not entitled to special terms, but receive assistance based on terms available to all recipients, including the terms regarding limitations on the amount received and repayment. An example of this type of program is the Capital Purchase Program.

To read the official press release on these changes, please click here.

• 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.

• Deadline. The application deadline is December 8, 2008. With this deadline less than three weeks away, all QFIs desiring to participate in the CPP should begin the application process immediately, unless already filed. A copy of the application, together with other information about the CPP, can be accessed by clicking here. (Note: The Treasury has not updated the application form, which still reflects a November 14th filing deadline.)
• S-corporations not Covered. The term sheet does not apply to S-corporations or mutual depository institutions. A separate term sheet for these entities has not been issued.

Like its public company counterpart, the private company term sheet summarizes the terms and conditions under which a QFI may sell shares of preferred stock to the Treasury. Although the provisions of this term sheet are similar to the public term sheet released in October, there are some notable differences. These differences include:

• Warrant Terms. The public term sheet requires CPP participants to grant the Treasury warrants to purchase the participant’s common shares. The warrants’ exercise price is based on the current market value of the participant’s common stock. Under the private term sheet, QFIs must grant warrants to purchase preferred shares. These warrants must have an aggregate liquidation preference equal to 5% of the preferred stock purchased by the Treasury. The warrants have an exercise price of $.01 per share and, although the warrants are exercisable for ten years, the Treasury intends to exercise them immediately.
• Other Dividend and Repurchase Restrictions. Under the private term sheet, after the tenth anniversary of the Treasury’s purchase of a QFI’s preferred stock, the QFI will be restricted from paying common dividends or repurchasing any equity securities or trust preferred securities until after the QFI redeems all of its equity securities held by the Treasury, or until the Treasury transfers all such equity securities to third parties.
• Dividend Increases. The public term sheet forbids participating institutions from increasing common dividends for the first three years after the date of the Treasury’s purchase of the institution’s preferred shares. The private term sheet includes additional restrictions on dividend increases. Not only must a QFI obtain the Treasury’s consent before increasing its common dividend during the three years following the Treasury’s purchase of the institution’s preferred shares, but for the time between the third and tenth anniversary of the Treasury’s purchase, the QFI must obtain the Treasury’s consent before increasing its common dividend by more than 3% per annum. This restriction is void once the preferred shares are redeemed or the Treasury transfers them to third parties.

To view our summary of the private term sheet, click here. To view the full text of the private term sheet, click here. Treasury has also provided a FAQ sheet regarding these new terms and is available by clicking here.

• 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.