• Treasury Publishes Capital Purchase Program Term Sheet for S Corporations
  • December 8, 2009 | Authors: Karen L. Grandstrand; Karla L. Reyerson
  • Law Firm: Fredrikson & Byron, P.A. - Minneapolis Office
  • On January 14, 2009, the U.S. Treasury released the term sheet that allows banks and bank holding companies that have elected Subchapter S tax treatment (S Corporations) to participate in the Capital Purchase Program (CPP), a program designed to infuse up to $250 billion in equity interests into U.S. financial institutions. This term sheet is the third set of terms to be released for the CPP. Publicly traded and privately held C corporations each received their own terms for participation late in 2008, which included the issuance of senior preferred stock. Mutual institutions continue to wait for their own term sheet and application deadline.

    S Corporations could not participate in the CPP under the terms provided for C corporations because doing so would have caused them to lose their Subchapter S tax status. This status allows the taxable income and losses of the entity to be passed through to its shareholders. In order to maintain Subchapter S status, S Corporations must, among other requirements, have only one class of stock (meaning no preferred shares), and their shareholders may only be natural persons or certain types of trusts (not government entities).

    In light of the restrictions placed on S Corporations, the Treasury will not take stock in S Corporations. Instead, the Treasury will purchase subordinated debentures. These debentures, or “Senior Securities,” have many of the same features and terms as the senior preferred shares issued by C corporations. A summary of these terms is provided below.


    The eligibility requirements for the S Corporations are largely the same as for C corporations except, of course, that these terms apply only to entities that have made a valid Subchapter S election. The Treasury will purchase Senior Securities from successful applicants at the highest-tier holding company level for banks that have a holding company. The Treasury will invest directly in successful bank applicants that do not have a holding company.

    Application Deadlines

    The deadline for S Corporations to apply to participate in the CPP is 5 p.m. EST February 13, 2009. Notably, the FAQ document that the Treasury released with the term sheet indicates that those S Corporations that have already applied for CPP funds do not need to reapply.

    Senior Securities

    The Treasury will purchase Senior Securities totaling between 1% and 3% of the risk-weighted assets of the entity. The Treasury has indicated that it will calculate these percentages based on the most recent call report on file at closing. If the amount requested at application is no longer within the 1% to 3% range at the time of closing, the applicant will need to adjust the amount requested. Applicants may also adjust the amount requested prior to closing.

    Where the Treasury invests at the holding company level, the Senior Securities will be considered Tier 1 capital. Where the Treasury invests at the bank level, the Senior Securities will be considered Tier 2 capital.

    The Senior Securities will be senior to the entity’s common stock but subordinated to claims by depositors and other debt obligations of the entity unless such debt obligations are explicitly made pari passu with or subordinated to the Senior Securities. As with the C corporation programs, the Senior Securities will not be subject to any contractual restrictions on transfer. They also will not be subject to the restrictions of any stockholders’ agreement or similar arrangement that is in effect among the entity and its stockholders at the time of the Treasury’s investment or thereafter.

    Cost of Senior Securities

    Each note representing a Senior Security will be in the principal amount of $1,000, and the maturity for each note is 30 years. The Senior Securities will pay interest at a rate of 7.7% per annum for the first five years, after which the rate will increase to 13.8% per annum. These rates are higher than the 5% and 9% rates under the C corporation programs, but the Treasury indicated that the reason for the higher rates under the S Corporation program is that the interest paid on the Senior Securities is tax deductible, while the dividends paid on the shares issued under the C corporation programs are not. Therefore, assuming a 35% tax rate, S Corporations will pay an after-tax effective rate on the Senior Securities that is equal to the dividend rates C corporations are paying.

    Any holding company that issues Senior Securities has the option of deferring interest for up to twenty quarters. However, any unpaid interest will cumulate and compound at the then effective interest rate. The holding company may not pay dividends on equity or trust preferred securities while interest is being deferred.


    Similar to the C corporation programs, the Senior Securities may not be redeemed during the first three years following the investment unless (1) the entity funds the redemption using only proceeds from a Qualified Securities Offering (meaning a sale for cash by the entity, after the date of the investment, of capital that is at least the same capital tier as the Senior Securities); and (2) the Qualified Securities Offering results in aggregate gross proceeds equal to 25% or more of the price of the Senior Securities when issued. A Qualified Securities Offering does not include sales made pursuant to agreements or arrangements entered into on or before January 15, 2009. It also does not include financing plans which were approved by the entity’s board or publicly announced prior to that date.

    After three years the entity may redeem the Senior Securities at will, though all redemptions are subject to the approval of the entity’s primary federal banking regulator. After the Senior Securities have been fully redeemed, the entity may redeem the related warrants, as discussed below.

    Voting Rights Related to Senior Securities

    The Senior Securities will not have voting rights, except that there will be class voting on (1) the authorization or issuance of equity securities that purport to rank senior to the Senior Securities; (2) any amendment to the rights of the Senior Securities; or (3) any merger, exchange, or similar transaction which would negatively impact the rights of the Senior Securities.

    The Senior Securities holders will gain the right to elect two directors after the entity has failed to pay interest in full for six periods, whether or not consecutive. The right to elect directors ends when all interest has been paid for all prior interest periods.

    Restrictions on Repurchases

    During the first ten years after the Treasury makes its investment, an entity must obtain the Treasury’s consent prior to repurchasing equity securities or trust preferred securities of the entity unless:

    • The Senior Securities and Warrant Senior Securities (see below) have been fully redeemed;
    • The Treasury has transferred all of the Senior Securities and Warrant Senior Securities to third parties; or
    • The entity is repurchasing shares in connection with a benefit plan in the ordinary course of business and consistent with past practices or relevant income tax law.

    Repurchases are also not allowed if interest payments on the Senior Securities are not current.

    Restrictions on Dividends

    An entity may not declare or pay dividends on shares of equity or trust preferred securities, nor may it repurchase or redeem shares of equity or trust preferred securities, until it has paid all accrued interest owed on the Senior Securities.

    For the first three years after the investment is made, an entity must obtain the Treasury’s consent prior to increasing its regularly paid dividends per share unless the Senior Securities and Warrant Senior Securities have been fully redeemed or have been transferred to third parties.

    After the third anniversary of the Treasury’s investment but prior to the tenth anniversary, the Treasury’s consent will be required for any increase in aggregate common dividends per share where the resulting dividend per share is greater than 103% of the prior year’s dividend rate per annum. No increase in dividends will be allowed as a result of a dividend paid in shares, a stock split or a similar transaction.

    S Corporations are allowed to increase dividends without the Treasury’s consent where the increase is solely proportionate to the increase in taxable income of the entity and distributed in order to cover the income taxes the shareholders must pay on the entity’s income. The Treasury and any of its successors may challenge the amount of proposed tax distributions if they believe such distributions exceed the amount necessary for the shareholders to pay their share of the entity’s income taxes.

    On or after the tenth anniversary of the Treasury’s investment, an entity may not pay any dividends or repurchase any equity securities or trust preferred securities until all of the Senior Securities and Warrant Senior Securities have been redeemed or repurchased.

    Executive Compensation Restrictions

    S Corporation participants must agree to the same restrictions on executive compensation during the time that the Treasury holds Senior Securities that apply to C corporation participants. These include (1) restrictions on incentives to take unnecessary and excessive risks that threaten the value of the financial institution; (2) clawbacks on paid bonuses and incentive compensation that was based on materially inaccurate earnings or other criteria; (3) restrictions on golden parachute payments; and (4) limits on tax deductions for executive compensation.

    These restrictions apply to the participant’s CEO and CFO, as well as the next three most highly paid executive officers of the entity (Senior Executive Officers). (A bank holding company must look at its own executives and the executives of its bank subsidiaries to determine the next three most highly paid executive officers, other than the holding company’s CEO and CFO.)

    Affiliate Transactions

    While the Treasury holds Senior Securities, participants and their subsidiaries are restricted from entering into transactions with related persons unless the such transactions are on terms no less favorable to the participant and its subsidiaries than could be obtained from an unaffiliated party. In addition, the entity’s audit committee or a group of independent directors must approve such transactions. If there are no independent directors, then the board must approve the transaction and keep written documentation supporting its determination that the transaction is on such comparable terms.

    Warrants for Senior Securities

    The Treasury will receive warrants to purchase a number of Senior Securities in an amount equal to 5% of the amount of Senior Securities purchased on the date of investment (Warrant Senior Securities). The exercise price for the warrants will be $.01 per note representing a Warrant Senior Security. The warrants have a 10-year term and are immediately exercisable. The Treasury intends to immediately exercise the warrants.

    The Warrant Senior Securities have the same rights, preferences, privileges, voting rights and other terms as the Senior Securities, except the interest on the Warrant Senior Securities will be 13.8% and the Warrant Senior Securities may not be redeemed until the Senior Securities have been redeemed.

    The warrants must not be subject to any contractual restrictions on transfer or restrictions of any stockholders’ agreement or similar arrangement.

    Though the term sheet does not mention any exception to the requirement for warrants for certified Community Development Financial Institutions (CDFIs), Treasury officials have indicated that the Treasury will likely decline to take Warrant Senior Securities from S Corporations that are CDFIs.

    Application Procedures and Considerations

    Pending Applications

    The information we have received is that pending applications will begin to move forward through the application process without any reapplication or communication from the applicants. Entities with pending applications are likely to receive a phone call from their bank’s primary regulator, though it may take several days for regulators to get to everyone. In addition, those with pending applications may be required to confirm that they have read the term sheet and related documents for S Corporations located on the Treasury’s website or to submit additional information.

    New Applicants

    Treasury officials have indicated that S Corporations should use the same application document and process that C corporations used to apply. The application is contained within the Application Guidelines document posted on the Treasury’s website at http://www.ustreas.gov/initiatives/eesa/docs/application-guidelines.pdf.

    A holding company that submits an application must send it to the Federal Reserve and the federal regulator of the largest bank it controls. A bank that does not have a holding company must submit the application to its primary federal regulator. These regulators must be contacted prior to the submission of the applications.

    Each applicant is required to describe any condition, including any representation or warranty, contained in the investment agreements and related documentation it must execute, with which the applicant cannot comply. The applicant may do this on the application or may attach a one-page explanation. The applicant also must provide a description (no longer than one page) of any mergers, acquisitions, or other capital raisings that are currently pending or are under negotiation, including the expected consummation date. The CEO or an authorized designee must sign the application. Regulators may request additional information to accompany the applications.

    Based on our experience in processing CPP applications, regulators, in reviewing applications, consider the viability of the entity. Therefore, in appropriate cases, entities may wish to provide information confirming viability. In addition, the incoming Obama Administration indicated in a letter to the leaders of Congress dated January 15, 2009 that healthy institutions receiving federal assistance under the Emergency Economic Stabilization Act of 2008 (EESA) will be required to increase their lending and report on their lending activity. Such institutions will also be required to implement mortgage foreclosure mitigation programs. The Administration stated that it intends to prevent EESA funds from being used to purchase healthy banks instead of to lend money. Entities may benefit from taking the Obama Administration’s expressed intentions for the use of EESA funds under consideration when submitting their applications.

    Each entity should identify any information contained in the application which it desires to keep confidential and request confidentiality for such information. Instructions for requesting confidentiality are contained in the Application Guidelines.

    The Treasury has indicated that applicants will be able to withdraw their applications under the CPP and that such withdrawals will not be made public. The Treasury also will not disclose any applications that are denied. The Treasury is encouraging those with applications pending that have determined not to participate to inform their regulators as soon as possible.

    As additional information related to the terms of participation in the CPP continues to be released, it will be important for institutions to reevaluate whether participation in the CPP makes sense for them. For those S Corporations that have not applied yet, you have until February 13, 2009 to do so if you wish to be considered for participation.