Against a backdrop of deteriorating domestic and overseas capital markets and the largest-ever one-week percentage drop in the U.S. stock markets, the Treasury Department changed the focus of its emergency action plan to make direct investments of $250 billion in U.S. financial institutions. The action, which was in response to a signal from the plunging equity markets that the $700 billion rescue plan insufficiently addressed capital shortfalls at domestic banks and financial institutions, will last only 10 weeks.
We note here the details of the plan and related actions by government agencies, what they mean to you, and our pledge to keep on top of this rapidly changing situation and report back as developments warrant.
Treasury announced yesterday that nine leading banks have already signed up to receive $125 billion under the new direct lending program. On board as of today are Bank of America, JP Morgan Chase, Goldman Sachs, Morgan Stanley, Merrill Lynch, Citigroup, Bank of New York Mellon and State Street. An additional $125 billion will be made available to 8,500 other banks and financial institutions.
In related moves:
The Bears Growled, and Treasury Took Heed
Late last week, in coordination with a number of European central banks, Treasury and the Federal Reserve announced that, using its authority under the Economic Emergency Stabilization Act, it would make direct investments in preferred stock of up to $250 billion in domestic financial institutions. Treasury also announced an increase on the limit of FDIC insurance of bank deposits to $250,000 and that it would insure without limit non-interest bearing deposits, which are primarily used by businesses. In response to the virtual shut-down of the commercial paper market, the Federal Reserve also announced last week that it would become a direct purchaser of commercial paper.
The Terms of the New Program
The details will largely drive the success or failure of the plan, and certainly the decision by financial institutions whether to participate. Here, then, are the key terms of Treasury's senior preferred stock investment program:
Generally US banks, US savings and loans, and holding companies that own US banks and savings and loans (collectively "QFIs"). Foreign banks and financial institutions are not eligible.
Preferred stock, which will rank senior (the "senior preferred") to common stock, and pari passu -- that is, on equal terms -- with existing preferred stock, except preferred stock that, by its very terms, is subordinated. The preferred stock will count as Tier 1 capital for regulatory purposes and have perpetuallife.
The senior preferred will pay a 5% dividend for the first five years, then increase to 9% thereafter. Dividends will be paid quarterly in arrears on each February 15, May 15, August 15 and November 15.
Treasury will be the initial holder, but the senior preferred will be freely transferable. QFIs will be required to file a shelf registration in respect of the senior preferred, and the holder will have "piggyback" registration rights.
Size of issue:
Each QFI will be eligible to sell Senior Preferred in an amount equal to not less than 1% of its risk-weighted assets, up to a limit of the lesser of $25 billion or 3% of its risk-weighted assets.
For the first three years, QFIs may not redeem the senior preferred, except from qualifying equity offerings. After three years, the senior Preferred may be redeemed at any time at the option of the QFI.
No dividends may be paid on junior securities or pari passu securities unless the dividends have been fully paid on the senior preferred. QFIs may not increase the dividends payable in respect of their common stock without the consent of Treasury so long as senior preferred is outstanding.
So long as the senior preferred is outstanding, QFIs may not repurchase or redeem any junior securities without the consent of Treasury.
The senior preferred will be non-voting, except for matters that adversely affect the senior preferred; however, if dividends on the senior preferred had not been paid for six quarters, the holder will have the right to elect two directors until dividend have been paid for four quarters.
So long as any senior preferred is outstanding, each QFI will be required to comply with the executive compensation limits established under the Act and to be implemented by forthcoming Treasury regulations. Those limits make certain salary payments in excess of $500,000 non-deductible for tax purposes and provide for the ability of a QFI to claw back certain bonus payments.
Each QFI that sells senior preferred stock will also issue to Treasury a 10-year warrant in an amount equal to 15% of the face amount of Senior Preferred issued to Treasury. The initial exercise price for the warrants will be equal to the market price (based on a 20-day trailing average) of the common stock of the QFI on the date that the Senior Preferred is issued.
What All This Means To You
Treasury intends to close on this additional funding by December 31, meaning that financial institutions considering participating should evaluate the terms of the program and act promptly if they are interested.
Many financial institutions are likely to view the issuance of senior preferred stock as an attractive way to augment existing capital at a time when liquidity is at a premium and obtaining private investment is difficult. Debt is ordinarily more attractive from a tax perspective than the issuance of preferred stock, interest being deductible and dividends not. The dividend on preferred stock, however, is low enough that financial institutions will and should view this as attractive money.
Copyright © 2008 Herrick, Feinstein LLP. The Credit Crisis Update is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.