United States: First Round Of Relief Under The Emergency Economic Stabilization Act

The Treasury Department has announced three programs under the Emergency Economic Stabilization Act passed by Congress on Oct. 3, 2008. The first is the TARP Capital Purchase Program (CPP). The CPP is intended to be available generally to any U.S. bank or savings association and certain U.S. bank holding companies and savings and loan holding companies. Two additional programs are being developed for institutions with "troubled" assets, including a program for systematically significant failed institutions (PSSFI) and the troubled asset auction program (TAAP).

The details of the CPP and executive compensation restrictions are summarized below. Treasury's announcement encourages participation and instructs applicants to work with their federal banking agency (FDIC, OTS, OCC, FRB). The development of approval criteria is moving at breakneck speed with new informal guidance being provided almost daily. One regional office of the FDIC has intimated in the last few days that healthy institutions are the most likely to be approved. Some in the industry believe that banks will be judged by their CAMELS score, and that those with poor scores may not be able to use the CPP to improve their capital position. Although CAMELS scores are confidential and not subject to disclosure, some industry players have been told that a denied application will be treated as an indication of a low score. Treasury will not disclose who it turned down, so an institution may want to consider carefully announcing that it is applying for the CPP, which means weighing in SEC disclosure obligations for reporting companies. Some also are hearing from their regulators that the intended use of the funds will be considered, which was not evident in the announcement from Treasury. We have heard informally that at least one regional office of the FDIC has told applicants that funds can be used for acquisitions as long as the target is identified in the application. This seems impractical, given the Nov. 14, 2008 deadline for application. All of these reports combine to underscore the rapidly evolving nature of the program and raise concerns over the potential inconsistencies in the application and approval process.

Capital Purchase Program

The CPP was announced by Treasury on Oct. 14, 2008. Financial institutions of all sizes and stages of financial health are now considering the opportunity to participate under this $250 billion program. Eight of the nation's largest commercial banks have already committed to sell an aggregate of $125 billion of senior preferred stock under the CPP, and regional banks, including Regions Financial Corp., have announced plans to participate in the program. Treasury has issued interim final rules outlining the terms of its investment in qualifying financial institutions (QFIs) through the purchase of senior preferred stock on terms listed in a term sheet. This is a summary of the terms:

• Participation must be for at least one percent of risk-weighted assets, up to a maximum of the lesser of $25 billion or three percent of risk-weighted assets.

• QFIs will issue to Treasury senior preferred stock with these features:

• No dividends can be paid on any other stock until dividends are fully paid on the senior preferred stock (except for dividends that rank pari passu with the senior preferred shares).

• No increases on common stock dividends for the first three years without consent of the Treasury.

• Treasury receives a warrant to purchase common stock with a value equal to 15 percent of the value of the senior preferred stock, exercisable at current market value (calculated on a 20-trading day trailing average).

• QFIs must register the senior preferred stock, warrants and underlying common stock on a shelf registration statement as soon as practicable after the date of Treasury's investment.

• Rules for institutions that are not public, or are mutual or Subchapter S corporations, are being developed.

• Deadline to apply for participation is Nov. 14, 2008.

Executive Compensation Restrictions

Financial institutions and their senior executives must, as a condition for participation in the CPP, ensure that all executive compensation arrangements comply with the following restrictions:

Eliminate incentives that reward "unnecessary and excessive risks." The compensation committee and the senior risk management officers of the financial institution are to review compensation incentives and ensure that they do not encourage officers to take "unnecessary and excessive" risks that are potentially harmful. The committee must also certify annually to federal banking regulators that it has reviewed and determined that the compensation programs of the institution meet this standard. Unfortunately, there is almost no guidance for determining which incentives reward excessive risk-taking. Speculation is that this provision is directed at incentives that would increase exposure to high-risk loans. The vagueness of this standard is troublesome.

Recoup or "claw-back" compensation. The rules require recoupment of compensation that is paid on performance metrics or financial results that are proven to be materially inaccurate. This is much broader than the Sarbanes-Oxley claw-back for restatement of financial statements.

Prohibit golden parachute payments on termination. A "golden parachute" is any severance paid on termination that is involuntary or related to the institution's insolvency, bankruptcy or receivership. These payments cannot equal or exceed an amount equal to three times the officer's annual compensation. Unlike Internal Revenue Code Section 280G change-in-control payment limitations, there are no exceptions to the CPP limits.

$500,000 deductibility limit. This limit remained unspecified in the statute but was added by Treasury as an "appropriate" standard of compensation and governance. Senior executive compensation over $500,000 is not deductible. Unlike Internal Revenue Code Section 162(m), there are no exceptions for performance-based pay (such as stock options), commissions or pre-existing agreements. This limit includes deferred compensation accruals, even if paid in a later year.

Scope and Duration of Restrictions. These restrictions apply to senior executive officers during the period that Treasury holds an equity or debt position under the CPP. These are the "named executive officers" under SEC reporting rules, which are the principal executive officer, the principal financial officer and the three other executives who receive the highest compensation. Institutions that are not subject to SEC reporting are to apply analogous rules to identify their senior executive officers.

Information Continues to Unfold

Institutions interested in participating in the CPP should note that additional details are forthcoming. Treasury plans to post on its website a detailed investment agreement and associated documentation, and each QFI must agree to be bound by the representations and warranties included in the investment agreement. At the time of this writing, the investment agreement was not yet available. Treasury has issued Q&A style rules on the CPP and details on the application procedure for institutions interested in participating. Treasury Secretary Paulson has indicated that the CPP is not being implemented on a first-come, first-served basis and has assured that there is sufficient capital to accommodate all qualified institutions that wish to participate.

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.