In our ongoing effort to provide our clients and friends of the firm with updated information and insight on developments related to legislation to support the financial markets, the Foley & Lardner LLP Financial Crisis Response Team is pleased to provide the following summary of today's events in Washington.
The Emergency Economic Stabilization Act of 2008 (the “Act”) has been signed into law. The key feature of the Act is the establishment of the Troubled Assets Relief Program (“TARP”), intended to restore liquidity and stability to the financial system. Foley & Lardner LLP will continue monitoring TARP and the development and implementation of its policies, procedures, and regulations. The following is an executive summary of TARP based on the provisions of the Act.
The Secretary of the Treasury (the “Secretary”) is authorized to purchase “troubled assets” from any “financial institution” and subsequently hold such assets or re-sell them in the marketplace at a price that maximizes the return to the government. The Secretary initially may have up to $250 billion of purchased assets (valued at the purchase price paid by TARP) outstanding at any one time, which effectively authorizes re-sales and re-purchases as long as the balance remains below that $250 billion limit. The President may increase this limit to $350 billion upon notification to Congress, and may subsequently increase the limit to $700 billion unless Congress adopts a joint resolution expressing disapproval. Authorization to purchase or sell assets extends through December 31, 2009 or, if directed by the Secretary, through October 3, 2010. However, the Secretary may hold previously-purchased assets beyond such date.
The new Office of Financial Stability, to be headed by an appointed Assistant Secretary of the Treasury, is authorized to designate financial institutions as “financial agents” of the government and to “establish vehicles” for purchasing, holding, and selling troubled assets. TARP operations may commence prior to the promulgation of regulations, and certain administrative and contracting requirements may be waived. However, promptly following the first purchase of troubled assets, the Secretary must publish program guidelines regarding criteria and methods for (a) identifying troubled assets for purchase, (b) pricing, valuing, and purchasing such assets, and (c) selecting asset managers. The Act establishes a range of oversight, reporting, and auditing requirements not discussed here.
Eligible Financial Institutions
Banks, savings associations, credit unions, insurance companies, and securities brokers or dealers are explicitly listed as eligible “financial institutions.” The Secretary may also permit any other institution to participate, provided that it has significant U.S. operations and is organized under U.S. federal or state/territorial law. The Act requires the Secretary to ensure participation by financial institutions of all sizes, types, and locations, and to consider, among other factors, (a) purchasing troubled assets from retirement plans and public entities (such as counties and cities), and (b) providing financial assistance to smaller financial institutions (assets less than $1 billion) whose capitalization suffered from the devaluation of the preferred stock of Fannie Mae and Freddie Mac.
There are two broad categories of eligible assets. (1) Residential or commercial mortgages, and any securities, obligations or other instruments based on or related to such mortgages, are eligible if (a) such mortgages were originated (or such instruments were issued) on or before March 14, 2008, and (b) the Secretary determines that the purchase of such mortgages or instruments would promote financial market stability. (2) Following consultation with the Federal Reserve and notification to Congress, the Secretary may also purchase “any other financial instrument” as deemed necessary to promote financial stability.
Purchase Price for Troubled Assets
Purchases may be made directly (by negotiation with TARP) or through mechanisms such as reverse auctions, in which holders of comparable assets compete to sell those assets to TARP at the lowest price. The Act requires that the Secretary pay no more for a troubled asset than the seller paid to purchase the asset (except for certain assets originally acquired through merger/acquisition or purchased by TARP from a bankrupt institution). This requirement is intended to prevent any “unjust enrichment” resulting from institutions selling troubled assets to the government at a profit. However, because asset sellers may have previously employed a variety of forms of consideration (including cash, notes, equity, property, or capital contributions) to acquire now-troubled assets, the above-described requirement may raise difficult valuation issues for such sellers and for TARP.
Warrants and Debt Instruments
A publicly-traded financial institution selling troubled assets to TARP must provide the Secretary with a warrant giving the Secretary the right to receive non-voting common stock (or voting common stock that the Secretary agrees not to vote) or preferred stock in the financial institution. A senior debt or equity instrument is required from an institution that is not publicly traded, and alternative arrangements are authorized for institutions legally barred from issuing securities or debt instruments. The requirements above are subject to a “de minimis exception” to be established by the Secretary, with the proviso that such de minimis exception level will not be available to any institution cumulatively selling more than $100 million of assets to TARP. TARP has complete authority to exercise, sell, or surrender such warrants, equity, or debt instruments. Thus, TARP could potentially create a public market for warrants or debt issued by even privately-held institutions.
Accountability Through Executive Compensation
Institutions selling assets to TARP are subject to executive-compensation restrictions generally described below. First, if the Secretary receives a “meaningful” equity or debt position in a financial institution through direct (non-auction) purchases of assets, the Secretary may (1) require “appropriate standards” for executive compensation so as to exclude incentives for excessive risk-taking; (2) prohibit certain “golden parachute” payments to senior executives during periods when the Secretary holds an equity or debt position; and (3) impose “claw-back” requirements to recover compensation previously paid to senior executives based on materially inaccurate financial statements. Second, for financial institutions that sell more than $300 million of assets to TARP through a combination of direct and auction purchases, any new employment contracts providing for certain golden parachute payments are prohibited. Third, if an institution sells more than $300 million of assets to TARP other than exclusively through direct purchases, then no tax deduction may be allowed for payments to a covered executive of (i) compensation (including deferred compensation) in excess of $500,000 or (ii) severance meeting certain golden parachute tests. The term “covered employee” includes the CEO, CFO, and any other employee among the three most highly-paid executives. The Secretary may prescribe guidance, rules, or regulations implementing these provisions.
To facilitate market transparency, the Secretary shall make publicly available (in electronic form, and within two business days of transactions) the description, amounts, and pricing of each purchase, trade, or other disposition. The Secretary shall also (a) determine whether each asset-selling institution has provided adequate public disclosure of its off-balance sheet transactions, derivatives instruments, contingent liabilities, and similar sources of potential exposure, and (b) make recommendations to relevant regulators if such disclosures are found to be inadequate to provide the public with the institution’s “true financial position.”
The Act requires the Secretary to establish a program to guarantee (rather than purchase) troubled assets originated or issued prior to March 14, 2008. The Secretary may guarantee timely payment of up to 100% of principal and interest payments. Institutions participating in the insurance program are not subject to the Act’s requirements regarding warrants, debt, or executive compensation. However, the Secretary is required to charge credit-risk based insurance premiums to create reserves sufficient to meet anticipated claims. Accordingly, the insurance may be very expensive, and institutions holding troubled assets will want to weigh such premiums against the costs of selling troubled assets outright, as well as the capital and liquidity implications of these alternative approaches.
The TARP-related portion of the Act also (1) authorizes the SEC to suspend mark-to-market accounting for any issuer or category of transaction; (2) provides ordinary loss treatment (subject to restrictions) for sales by financial institutions of the now-devalued preferred stock of Fannie Mae and Freddie Mac; (3) increases the FDIC deposit-insurance limit from $100,000 to $250,000 through December 31, 2009; (4) accelerates to October 1, 2008 (rather than October 1, 2011), the authority of Federal Reserve Banks to pay interest on the required reserves maintained by banks; and (5) requires, after five years, that the President submit a proposal to recoup from the financial industry any net losses to TARP.
Foley & Lardner LLP is currently preparing a more comprehensive analysis of the Act and its potential impact on clients. Please e-mail Cheryl Winkowski at firstname.lastname@example.org if you would like that analysis to be e-mailed to you when it becomes available later this week.