During 2008 and 2009, the U.S. Treasury Department (Treasury) purchased cumulative preferred stock from more than 700 U.S. bank holding companies (BHCs) as part of the Capital Purchase Program established under its Troubled Asset Relief Program (TARP).
By the end of 2011, Treasury had exited approximately half of these positions and announced that it had reached breakeven on its aggregate bank investments. With all future proceeds now constituting profit, Treasury engaged financial advisers to explore alternatives for refinancing or selling the remaining TARP preferred stock. In March 2012, Treasury announced completion of an auction under which it sold the TARP preferred stock of six BHCs, with two of those companies repurchasing their own TARP preferred stock at discounts of 5.6% and 6.9%, and third-party investors purchasing the other four TARP positions at discounts ranging from 8.5% to 18%. 
On May 3, 2012, the Assistant Treasury Secretary announced that the TARP preferred stock auctions would continue as part of the TARP winddown. Additionally, at least 12 BHCs have filed registration statements covering TARP preferred stock since completion of the March auction, sending a strong signal that additional auctions will be held over the next few months.
With a dividend rate that increases from 5% to 9% over the next two years, and purchase discounts of up to 18% or more, TARP preferred stock may be an attractive potential investment for a private fund seeking mid-to-high-teen returns. When formulating a bid for TARP preferred stock, however, a private fund manager should understand the regulatory and similar limitations that may affect the value of such an investment, particularly those relating to dividend payments, redemptions and "control" of a BHC.
Guidance from regulators suggests that a BHC's board of directors should not approve a dividend if it exceeds (a) earnings for the past four quarters less (b) dividends paid during that period. Banking regulators also have imposed formal and informal restrictions on many banks and BHCs requiring regulatory approval of all dividend payments and prescribing significantly higher capital ratios. As loan losses diminish, bank earnings solidify and capital levels increase, we expect regulators to reduce or remove these additional restrictions, but banking regulators' resolve and the inclination of many TARP participants to maintain high levels of capital and retain excess cash may persist.
Although dividends under the TARP preferred stock accumulate, there is risk that dividends will not be paid in a timely manner.
Typically, the Federal Reserve must approve any stock redemption by a BHC that would (a) reduce its consolidated net worth by 10% or more or (b) have a material adverse impact on the level or composition of its capital. For most of the remaining TARP participants, at least one of these two conditions will exist unless they raise additional common equity or non-cumulative preferred stock, and many issuers have been unwilling or unable to raise this type of equity. 
Furthermore, once Treasury transfers TARP preferred to a third party, certain contractual restrictions on the BHC in favor of Treasury - which otherwise would incentivize the BHC to redeem the TARP preferred stock - are eliminated, including (i) limits on executive compensation, (ii) the requirement that Treasury approve dividend increases in excess of 3% (or, after the tenth anniversary, the prohibition on the payment of any dividends) and (iii) the prohibition on the redemption or purchase of equity securities other than pursuant to prior contractual commitments (or, after the tenth anniversary, the prohibition on any redemptions or purchases of equity). 
Private fund managers should be mindful that TARP preferred stock is a perpetual security and does not include redemption rights exercisable at the holder's option.
A Control Determination
Although TARP preferred stock is non-voting, a private fund may risk being deemed to "control" the BHC issuer if its TARP preferred stock constitutes 25% or more of the issuer's total capital, which could be the case for many of the TARP issuers in question. In addition, a private fund may be deemed to control the BHC because the terms of the TARP preferred stock permit its holder to appoint two directors to the BHC's board of directors if six dividend payments are not made.
If the Federal Reserve determines that a private fund is in "control" of a BHC, the private fund itself could be subject to regulation under the Bank Holding Company Act.
To avoid such a determination, a private fund may be required to execute passivity commitments and/or waive its right to appoint one or both of the directors before it acquires any TARP preferred stock. Private fund managers should become familiar with the limitations imposed under passivity commitments and the recent actions that the Federal Reserve has taken to prevent the exercise of influence by investors that have not obtained required approvals.
 Prior to the March TARP auction, most cases in which Treasury accepted a discount on the disposition of TARP preferred stock involved private equity firms providing capital to a severely troubled BHC on the condition that the BHC redeem its TARP preferred stock (for cash or for publicly traded common stock) at a deep discount.
 Because a BHC typically pays dividends out of the dividends received from its bank subsidiary, restrictions on a bank's payment of dividends to the BHC directly impact the BHC's ability to pay dividends.
 Under Dodd-Frank Wall Street Reform and Consumer Protection Act Section 171, cumulative preferred stock issued after May 2010 (other than TARP preferred stock) will not qualify for tier one capital treatment.
 TARP preferred stock terms restricting any payment (whether by dividend or redemption) in respect of junior securities, including a BHC's common stock, when the dividends on the TARP preferred are not current will survive any transfer to a third party.
Edwin S. del Hierro, P.C., Partner, firstname.lastname@example.org
Edwin del Hierro is a partner in the Corporate Practice Group of Kirkland & Ellis LLP and heads our bank regulatory practice. He has more than 25 years of experience in representing banks and bank holding companies, thrifts and thrift holding companies, investment banks and institutional lenders in connection with regulatory issues. He has significant experience representing private equity and other investors in both control and non-control investments in financial institutions and advises some of the largest banks in the United States in the design and development of capital-qualified debt and equity products.
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Julie Kunetka, Of Counsel, email@example.com
Julie Kunetka is Of Counsel in the Corporate Practice Group with extensive experience in complex transactions and regulatory matters involving regulated financial institutions, including banks, thrifts and financial holding companies.
Full Bio (http://www.kirkland.com/sitecontent.cfm?contentID=220&itemID=10033)
Kirkland & Ellis LLP
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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Kirkland & Ellis LLP. This work reflects the law at the time of writing in May 2012.