The TARP Capital Purchase Program Q&A

October 15, 2008

In an effort to help institutions unfreeze lending and spur economic growth, the Federal government—drawing on funds from the recently passed $700 billion bank rescue plan—will commit up to $250 billion to purchase preferred equity shares in financial institutions, with $125 billion of that amount directed at nine large financial institutions.  The remaining $125 billion will be directed to small and midsize institutions that must elect to participate in the program by November 14, 2008.  Allocation decisions will be made thereafter, following consultation with the appropriate banking agency (Treasury Announces TARP Capital Purchase Program Description).  The capital infusion plan was formulated jointly by the U.S. Department of Treasury (the "Treasury"), the Board of Governors of the Federal Reserve System (the "Fed") and the Federal Deposit Insurance Corporation (the "FDIC") and is accompanied by efforts to allow the FDIC to temporarily guarantee, for a fee, certain types of new debt called senior unsecured debt issued by banks and thrifts, and for the Fed to finalize a program to serve as a buyer of last resort for commercial paper.

Seeking to balance protections for taxpayers against the equity positions of existing shareholders and investors of the participating financial institutions, the government plan is a complex set of legal and financial terms ranging from curbs on executive compensation to restrictions on dividends and rights of preferred shareholders (Summary of Senior Preferred Terms).  In an effort to help firms keep pace with these fast-moving developments, Bracewell & Giuliani has highlighted some fundamental questions raised by these new programs.

The TARP Capital Purchase Program

What types of financial institutions are eligible to participate in the program?
The TARP Capital Purchase Program (the "CPP") is available to "Qualifying Financial Institutions," ("QFI") which are defined as:

• any U.S. bank or U.S. savings association not controlled by a Bank Holding Company ("BHC") or Savings and Loan Holding Company ("SLHC");
• any U.S. BHC or any U.S. SLHC which engages only in activities permitted for financial holdings companies under Section 4(k) of the Bank Holding Company Act, and any U.S. bank or U.S. savings association controlled by such a qualifying U.S. BHC or U.S. SLHC; and
• any U.S. BHC or U.S. SLHC whose U.S. depository institution subsidiaries are the subject of an application under Section 4(c)(8) of the Bank Holding Company Act; except that QFI shall not mean any BHC, SLHC, bank or savings association that is controlled by a foreign bank or company.

For purposes of the program, "U.S. bank," "U.S. savings association," "U.S. BHC" and "U.S. SLHC" means a bank, savings association, BHC or SLHC organized under the laws of the United Sates or any State of the United States, the District of Columbia, any territory or possession of the United States, Puerto Rico, Northern Mariana Islands, Guam, American Samoa, or the Virgin Islands.

Do non-public institutions qualify for the CPP?
Yes.  The CPP is available to all QFIs as noted above.  However, the public term sheet does not provide for terms applicable to investments under the CPP in non-public institutions.  We anticipate additional guidance from the Treasury regarding the specific terms to be applied to non-public institutions to be released in the coming days.

What will be the minimum and maximum subscription amount available to participating financial institutions?
The minimum subscription amount available is 1 percent of risk-weighted assets.  The maximum subscription amount is the lesser of $25 billion or 3 percent of risk-weighted assets.  The Treasury will determine eligibility and allocations for interested parties after consultation with the appropriate federal regulators.  We assume that risk-weighted assets will be measured as of September 30, 2008, but that detail has not yet been formalized.

How will an institution indicate its desire to participate in the CPP?
Institutions interested in participating in the CPP should contact their primary federal regulator for specific details.  We would be pleased to assist you in this process.

Is there a deadline for participation in the CPP?
Yes.  An institution must elect to participate in the CPP before 5:00 p.m. (EDT) on November 14, 2008.

When will funding occur?
The Treasury currently plans to fund the senior preferred shares (the "Senior Preferred") purchased under the CPP by the end of 2008.

Will the Senior Preferred qualify as Tier 1 capital?
Yes.  The full dollar amount of the Senior Preferred will qualify as Tier 1 capital.

How will the Senior Preferred rank in comparison to other capital stock?
The Senior Preferred will rank senior to common stock and pari passu, an equal level in the capital structure, with existing preferred shares, other than preferred shares which by their terms rank junior to any other existing preferred shares.  Junior subordinated debt supporting trust preferred stock ranks senior to the Senior Preferred.

What dividend will the Senior Preferred pay?
The Senior Preferred will pay a cumulative dividend rate of 5 percent per year for the first five years and will reset to a rate of 9 percent per year after the fifth year.  In our view, relative to recent transactions, this is relatively inexpensive capital.  For Senior Preferred issued by banks which are not subsidiaries of holding companies, dividends will be non-cumulative.  Dividends will be payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year.

Are there any restrictions on dividends?
Yes.  For as long as any Senior Preferred is outstanding, no dividends may be declared or paid on junior preferred shares, preferred shares ranking pari passu with the Senior Preferred, or common shares, nor may any institution repurchase or redeem any junior preferred shares, preferred shares ranking pari passu with the Senior Preferred or common shares, unless:

• in the case of cumulative Senior Preferred, all accrued and unpaid dividends for all past dividend periods on the Senior Preferred are fully paid; or
• in the case of non-cumulative Senior Preferred, the full dividend for the latest completed dividend period has been declared and paid in full. 

Additionally, the Treasury's consent is required for any increase in dividends per share paid on common shares until the third anniversary of the date of the Senior Preferred investment, unless prior to that date, the Senior Preferred is redeemed in whole or the Treasury has transferred all of the Senior Preferred to third parties.  In the case of a BHC or SLHC, the CPP does not impose any restrictions on dividends paid to the holding company by any subsidiary bank.

Are the Senior Preferred redeemable?
Yes.  The Senior Preferred will be redeemable at par after three years.  Prior to the end of three years, the Senior Preferred may be redeemed with the gross proceeds from a qualifying equity offering of any Tier 1 perpetual preferred stock or common stock, provided that the gross proceeds are at least equal to 25 percent of the aggregate issue price of the Senior Preferred.  A "qualifying equity offering" means the sale by the issuer of Tier 1 qualifying perpetual preferred stock or common stock for cash after the date of the Senior Preferred investment.  Additionally, the Senior Preferred may be redeemed in whole or in part at the option of the issuer after three years.  After the redemption in whole of the Senior Preferred held by the Treasury, the issuer will have the right to purchase any other equity security of the issuer held by the Treasury at fair market value.

Are the Senior Preferred transferable?
Yes.  The Treasury may transfer the Senior Preferred to a third-party at any time without the issuer's consent.
 
Will warrants be issued in conjunction with the purchase of Senior Preferred?
Yes.  Each QFI that issues Senior Preferred must issue to the Treasury warrants to purchase common stock with an aggregate market price equal to 15 percent of the Senior Preferred investment, subject to reduction as described below.  The initial exercise price on the warrants will be the market price of the participating institution's common stock on the date of the Senior Preferred investment, calculated on a 20-trading day trailing average.  Additionally, there will be a 50 percent reduction in the number of shares of common stock underlying the warrants if, on or before December 31, 2009, the issuer of the Senior Preferred raises gross proceeds from one or more qualifying equity offerings in an aggregate amount not less than 100 percent of the Senior Preferred issue price.  The warrants have a 10-year maturity.  Again, based on recent market transactions, we view this feature as being relatively favorable to the issuer.

When are the warrants exercisable?
The warrants may be exercised at any time, in whole or in part, provided that the Treasury may only exercise 50 percent of the warrants prior to the earlier of:

• the date on which the issuer has received gross proceeds of not less than 100 percent of the issue price of the Senior Preferred from one or more qualifying equity offerings; and
• December 31, 2009.

What if a QFI does not presently have enough authorized shares of common stock underlying the warrants or is required to obtain shareholder approval for the issuance under applicable stock exchange rules?
The QFI must call a shareholder meeting as soon as practicable after the Senior Preferred investment to increase the number of its authorized shares of common stock and/or comply with applicable stock exchange rules. The exercise price of the warrants will be reduced by 15 percent of the original exercise price on each six-month anniversary of the warrant issue date if the shareholder approval has not been received, up to a maximum reduction of 45 percent of the original exercise price.

Will the Treasury have any substitution rights with respect to the warrants?
Yes.  In the event a participating institution is no longer listed or traded on a national securities exchange or securities association, or the consent of a participating institution's stockholders has not been received within 18 months after the issuance date of the warrants, the warrants will be exchangeable, at the option of the Treasury, for senior term debt or another economic instrument or security of the participating institution, such that the Treasury is appropriately compensated for the value of the warrant, as determined by the Treasury.

Will the Treasury have voting rights on the Senior Preferred?
Maybe.  The Senior Preferred will be non-voting, other than class voting rights on:

• any authorization or issuance of shares ranking senior to the Senior Preferred;
• any amendment to the rights of Senior Preferred; or
• any merger, exchange or similar transaction which would adversely affect the rights of the Senior Preferred.

If dividends on the Senior Preferred are not paid in full for six dividend periods, whether or not consecutive, the Senior Preferred will have the right to elect two directors.  The right to elect directors will end when full dividends have been paid for four consecutive dividend periods.

Will the Treasury have voting rights on any shares of common stock?
No.  The Treasury will agree not to exercise voting power with respect to any shares of common stock of the institution issued to it upon exercise of the warrants.

Are there any executive compensation restrictions for participating institutions?
Yes.  As a condition to the closing of the Senior Preferred investment, the participating institution and its senior executive officers covered by the Emergency Economic Stabilization Act (the "EESA")¹ are required to modify or terminate all benefit plans, arrangements and agreements (including golden parachute agreements) to the extent necessary to be in compliance with the executive compensation and corporate governance requirements of Section 111 of the EESA and any guidance or regulations issued by the Treasury on or prior to the date of the investment.  This condition shall be in effect for so long as the Treasury holds any equity or debt securities of the participating institution.

Specifically, the participating institution must:

• ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the participating institution;
• require clawback of any bonus or incentive compensation paid to a senior executive based on statement of earnings, gains or other criteria that are later proven to be materially inaccurate;
• prohibit the participating institution from making any golden parachute payment to a senior executive based on section 280G of the Internal Revenue Code (the "IRC"); and
• agree not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive.

As an additional condition to the closing, the participating institution and its senior executive officers covered by the EESA must grant the Treasury a waiver releasing the Treasury from any claims that the participating institution and such senior executive officers may otherwise have as a result of the issuance of any regulations which modify the terms of benefits plans, arrangements and agreements to eliminate any provisions that would not be in compliance with the executive compensation and corporate governance requirements of Section 111 of the EESA and any guidance or regulations issued by the Treasury on or prior to the date of this investment to carry out the provisions of such subsection.  We view the executive compensation provisions of the program to present the most challenges for institutions applying for the capital, especially for institutions that may be sold while the Treasury is a shareholder.

Are there any shelf registration requirements for publicly traded BHCs?
Yes.  The CPP requires shelf registration for the Senior Preferred, the warrants and the common stock underlying the warrants.

Are there any other issues my institution needs to be aware of?
Yes.  Currently, it is unclear how, or if, subchapter S institutions can participate in the program without jeopardizing the S election or obtaining relief from the IRS.  Also unclear are the requirements, if any, surrounding the new funding and what that funding can be used for.  Implications for not applying to the program are unclear as well, as are implications of applying and not being selected.  Furthermore, it is uncertain whether there will be any additional qualifications for public and/or private institutions participating in the CPP.

Securities Implications

Will the submission of an application under the CPP require the filing of a Form 8-K?
Not initially.  The submission of an application will not itself trigger a requirement to file a Form 8-K, and the Treasury has not indicated any necessary disclosure.  However, the submission may constitute material non-public information, the selective disclosure of which would be prohibited by Regulation FD.  Upon closing of the issuance, the unregistered sale of the Senior Preferred to the Treasury and the amendment of executive compensation plans in compliance with the Program would both require disclosure on Form 8-K.

Will the Treasury resell the securities?
Maybe.  The Treasury is expressly requiring the right to resell the Senior Preferred and the warrants to a third party at any time. 

Will the securities be registered?
Yes, after issuance.  The public term sheet provided by the Treasury contemplates that the initial sale to the Treasury will be an unregistered private placement.  Pursuant to the term sheet, issuers will be required to file shelf registrations as soon as practicable following the issuance registering the resales of the Senior Preferred, the warrants and the common stock underlying the warrants.  Issuers must also grant the Treasury piggyback registration rights as to the securities.  Issuers must apply for listing of the common stock underlying the warrants on the national securities exchange where the common stock currently trades, and, if requested by the Treasury, issuers must apply for listing of the Senior Preferred or appoint a depositary for the Senior Preferred and issue depositary shares.  The public term sheet does not contemplate the registration of the securities under effective shelf registration statements.  The public term sheet also does not contemplate how non-public banks would satisfy this requirement.

Will shareholder approval be required?
Probably not.  Provided that a sufficient number of shares of common stock underlying the warrants are authorized and such number of shares constitutes less than 20 percent of the outstanding common stock of the issuer, no shareholder approval would be required under SEC, NYSE or Nasdaq rules.  Even if the shares of common stock underlying the warrants constitute more than 20 percent of the common stock outstanding, an exception may be permitted if the delay necessary for shareholder approval may jeopardize the financial viability of the issuer.

Tax Implications

Will stock issued to the Treasury cause the Treasury's ownership in a corporation to increase for purposes of determining whether an ownership change occurred under IRC Section 382?
No.  Capital stock issued to the Treasury pursuant to the CPP will not increase the Treasury's ownership in such corporation; therefore, the capital stock issued to the Treasury under the CPP alone will not trigger an ownership change under IRC Section 382 with respect to such corporation.

Will the warrants issued to the Treasury under the CPP be treated as stock under IRC Section 382?
No.  Warrants issued to the Treasury will be classified as options rather than stock and such options held by the Treasury will not be deemed exercised for purposes of applying IRC Section 382. 

Will amounts furnished to a loss corporation by the Treasury increase the value of such loss corporation for purposes of determining the annual limitation on loss carryovers under IRC Section 382?
Yes.  Capital contributions that the Treasury provides pursuant to the CPP will not be considered to have been made as a part of a plan a principal purpose of which was to avoid or increase the loss corporation's IRC Section 382 limitation; thus, such contributions could increase the amount of net operating loss carryovers available after an ownership change.

Will the amounts furnished to a financial institution by the Treasury be considered the provision of Federal financial assistance under IRC Section 597?
No.  Amounts furnished to a financial institution under the TARP will not be treated as the provision of Federal financial assistance under IRC Section 597 and therefore should not result in income with respect to such financial institution.

FDIC Liquidity Program

What is the FDIC Liquidity Program?
The FDIC Liquidity Program (the "Program") is a new plan that provides the guarantee of new, senior unsecured debt issued by any FDIC-insured depository institution, U.S. bank holding company, U.S. financial holding company and U.S. savings and loan holding companies that engage only in activities that are permissible for financial holding companies to conduct under section 4(k) of the Bank Holding Company Act (the "Eligible Institutions").  The Program is designed to help banks fund their operations, and will allow banks and their holding companies to roll senior debt to new issues fully backed by the FDIC.

What types of liabilities are eligible for coverage?
The FDIC guarantee would apply only to all newly issued senior unsecured debt issued by the Eligible Institutions on or before June 30, 2009, including: promissory notes, commercial paper, inter-bank funding and any unsecured portion of senior debt.  We believe Fed Funds would qualify as "inter-bank" funding; however, likely only newly issued Fed Funds would be eligible for coverage.
 
What is the formula for debt coverage?
Debt covered by the guarantee must not exceed 125 percent of debt that was outstanding as of September 30, 2008 that was scheduled to mature before June 30, 2009.

What is the time frame for coverage of the debt?
Eligible debt issued on or before June 30, 2009 would only be covered for three years beyond that date, regardless of if the debt has not matured.

What types of deposits are the eligible for coverage?
Funds in non-interest-bearing transaction deposit accounts held by the FDIC-insured bank until December 31, 2009 are eligible.

What are the fees for the Program and when will the guarantees expire?
The fees for the Program are waived for the first 30 days; thereafter, newly issued unsecured debt would be assessed a fee of 75bps x the amount of debt issued, and non-interest-bearing transaction deposit accounts (which would not otherwise be covered by the current $250,000 insurance limit) would be assessed a 10bps surcharge added to existing risk-based deposit insurance premiums.  Eligibility will expire on June 30, 2009; beyond the initial 30 days of coverage, Eligible Institutions must inform the FDIC if they desire to opt-out of the Program.

How Bracewell Can Help

How can legal counsel help you?
We are prepared to help you evaluate the CPP and participate in the CPP if you determine it is prudent to do so. Specifically, we are available to:

• discuss with you strategic reasons to participate in the CPP;
• assist with the examination of your institution's Articles of Incorporation/Association to facilitate the issuance of Senior Preferred and a sufficient number of shares of common stock;
• evaluate the terms of any existing preferred securities as to ranking and related issues;
• assist in the procedures and documentation for any required shareholder meeting;
• assist with various requests to both state and federal regulators as necessary;
• assist public companies with the preparation and filing of any required Form 8-K and other public disclosures;
• assist public companies with shelf registration of the Senior Preferred, the warrants and the common stock underlying the warrants;
• assist non-public companies with whatever equivalent to shelf registration will be required; and
• help you navigate the impact of the program on any employment agreements, change-in-control agreements, benefit plans and related documents and assist with  any required amendments.

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¹ The EESA defines "senior executive officer" as an individual who is one of the top five highly paid executives of a public company, whose compensation is required to be disclosed pursuant to the Securities Exchange Act of 1934, and any regulations issued there under, and non-public company counterparts.