The United States Treasury has released term sheets to provide guidance to Subchapter S corporations and mutual institutions contemplating an investment from Treasury under the Small Business Lending Fund.  It is important to note that the application deadline for S Corps and mutual institutions is June 6, 2011. 

Similar to its approach in the TARP Capital Purchase Program for both S Corps and mutual institutions, Treasury requires that these participating entities issue unsecured subordinated debentures (referred to as Senior Securities in the term sheets) that do not constitute a class of stock or represent equity ownership of the issuing entity.  Following is a brief summary and analysis of the key provisions of the S Corps and mutual institution term sheets.  This discussion does not address the multitude of provisions that S Corps and mutual institutions would have in common with C corporation issuers of SBLF senior preferred stock, including eligibility limits regarding problem bank status and asset size thresholds, the permissible investment amounts, voting rights, transfer restrictions, dividend restrictions, increased oversight following missed interest payments, investment down-streaming requirements and the small business lending plan.  To review the S Corp and mutual institution term sheets in their entirety, or to access an application form, click here.

Regulatory Capital Treatment — The Senior Securities will constitute Tier 2 capital for the issuer.  We note that this is an important distinction from the subordinated debt issued under the TARP CPP and from the SBLF senior preferred stock issued by C corporations, both of which constitute Tier 1 capital. We believe that this less favorable capital treatment will discourage many potential applicants.  However, a small bank holding company—a BHC with less than $500 million in total assets—is not subject to the Federal Reserve’s capital adequacy guidelines and, therefore, should be less concerned with the regulatory capital treatment of the Senior Securities, the proceeds of which can be downstreamed to the subsidiary bank and the count as Tier 1 capital at that level.

Interest Rate — The Senior Securities must pay cumulative quarterly interest (unlike the non-cumulative quarterly dividends payable by C corporations).  The initial APR for the Senior Securities is 7.7%.  This initial interest rate (a) will decrease if the issuer increases its qualified small business lending and (b) will increase over time if the Senior Securities remain outstanding.  The following chart reflects how the interest rate may vary depending on (a) and (b). 

*For the first nine quarters, the interest rate will be adjusted quarterly

We note that although the interest rates applicable to S Corps participating in the SBLF are higher than the dividend rates payable by C corporations, the rates are designed to be equivalent on an after-tax basis.  Also, due to the interest rate hike to 13.8% after 4.5 years (regardless of the level of qualified small business lending the issuer has underwritten), SBLF participants should create a plan now to refinance these Senior Securities within 4.5 years when the cost of an SBLF investment will increase substantially.

Ranking — The Senior Securities will rank senior to common stock (for S corporation) or mutual capital certificates (for mutuals) but (i) if issued by a bank or savings association, the Senior Securities will be expressly subordinated to the claims of depositors and the issuer's other debt obligations, and (ii) if issued by a holding company, the Senior Securities will be subordinated to senior indebtedness of the issuer, unless in the case of either (i) or (ii), such debt obligations are expressly made pari passu or subordinate to the Senior Securities. This ranking will be functionally the same as C corporations for most SBLF participants.

Maturity Date — The Senior Securities will mature ten years after the date of issuance.  We note that this is a much shorter term that the 30-year maturity for the subordinated debt issued under the TARP CPP and CDFI and is obviously less favorable than C corporation SBLF participants which have no maturity date on the SBLF senior preferred stock. As noted above, however, due to the higher interest rates S Corps and mutuals should not wait for this maturity deadline to plan to refinance their Senior Securities.

Mutuals with a Mid-Tier Stock Holding Company — We also note that mutual holding companies with a mid-tier stock holding company must apply for SBLF funding at the mid-tier holding company level under the terms for C corporations issuing senior preferred stock.

There are also a few similarities to the SBLF C corporation program terms that are worth noting.                        

No Relationship to TARP — Participation in the SBLF will not cause a participating institution to be considered a TARP recipient.  This is an important provision because it means that SBLF participants, including those who use SBLF funds to repay TARP CPP or CDCI obligations, will not be subject to the TARP executive compensation and corporate governance restrictions.

Change in Law — A participant in the SBLF program may withdraw from the program if, after the participant has received SBLF funding, there is a change in law that modifies the program's terms in a materially adverse respect.  Before it withdraws, the SBLF participant will be required to consult with its federal banking regulator.  But subject to this consultation, it will be able to withdraw without impediment (assuming the SBLF participant’s capitalization post-withdrawal would be sufficient).  Given the current political climate, including an amendment to the program proposed by Sen. Olympia Snowe, this provision should provide some assurances to a potential SBLF participant that it will not be trapped in a program for which it did not sign up.

Concluding Thoughts

The Senior Securities' status as Tier 2 instruments will undoubtedly make the program less desirable for many potential applicants.  Further, the extremely brief application period means that S Corps and mutual institutions must decide quickly whether to apply.  However, even if an eligible institution is uncertain about participating in the SBLF program, given the minimal time required to complete an application and small business lending plan, it should prepare and submit an application by the June 6^th deadline.  Submitting an application does not obligate an applicant to actually participate in the SBLF.

Treasury has yet to approve any SBLF applications submitted under the C corporation program.  Nevertheless, Don Graves, the Deputy Assistant Treasury Secretary in charge of the SBLF, said last week that Treasury will make decisions on the first round of funding within the next few weeks, and that participants should receive the money in June. He also indicated that Treasury still intends that all funds will be distributed to participants on or before September 27, 2011, which is the deadline set by the legislation establishing the SBLF.

Given these short deadlines for applying for this program, if you have any questions regarding the SBLF application process, or if you are debating whether SBLF funding is appropriate for your institution, please contact Len Rubin at len.rubin@nelsonmullins.com, (202) 712-2885 or Ben Barnhill at ben.barnhill@nelsonmullins.com, (864) 250-2246 for assistance.