With the unprecedented restructuring of U.S. financial markets and institutions, many businesses and individuals now face a host of new and evolving challenges and opportunities. In our ongoing effort to provide our clients and friends of the firm with updated information and insight on developments related to action to support the financial markets, the Foley & Lardner LLP Financial Crisis Response Team is pleased to provide the following comprehensive summary of the Emergency Economic Stabilization Act of 2008 (Act), which was signed into law on October 3, 2008.
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. The following is a summary and an analysis of TARP based upon the provisions of the Act and recently published announcements by the United States Department of the Treasury (Treasury Department). This summary expands upon our executive briefing dated October 5, 2008 which can be found at http://www.foley.com/news/news_detail.aspx?newsid=3605.
The Secretary of the Treasury (Secretary) is authorized to purchase “troubled assets” from any “financial institution” and hold these assets or subsequently 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 at or below that $250 billion limit. Thus, the $250 billion limit is not a ceiling on the total amount that may be spent over time.
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 extends through December 31, 2009 or, if directed by the Secretary, through October 3, 2010. However, the Secretary may hold and re-sell previously purchased assets beyond the TARP termination date.
Eligible Financial Institutions
The Act expressly states that banks, savings associations, credit unions, insurance companies, and securities brokers or dealers will be eligible financial institutions from which troubled assets may be purchased.
However, the Act authorizes the Secretary to permit “any other institution” to participate, provided that it has “significant U.S. operations,” is organized under U.S. federal or state/territorial law, and is neither a foreign central bank nor owned by a foreign government.
The definition of eligible financial institution was in part designed to enable U.S.-based subsidiaries of foreign financial institutions to qualify for TARP, even when such foreign banks and/or central banks would not themselves qualify. However, a separate provision of the Act permits even foreign banks without a U.S. presence and foreign central banks to sell assets to TARP if those assets were acquired as a result of extending financing to financial institutions that have failed or have defaulted on such financing.
The Act gives the Secretary broad discretion to buy assets from other institutions such as retirement plans and municipalities. Moreover, the reference to retirement plans indicates that it is not fatal if the institution lacks significant U.S. operations.
There are two broad categories of eligible assets.
(1) Mortgages and Mortgage-Backed Securities
Residential or commercial mortgages, and any securities, obligations, or other instruments based upon or related to such mortgages, are eligible if both (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.
The Treasury’s recent Request for Proposals (RFP) for asset-management services indicated that the whole loan assets may include “residential first mortgages, home equity loans, second liens, commercial mortgage loans, and possibly other types of mortgage loans acquired to promote market stability.” Thus, even assets that are not standard first-lien mortgages may qualify.
The RFP indicates that the securities to be selected for the TARP portfolio include “Prime, Alt-A, and Subprime residential mortgage-backed securities (MBS), commercial MBS, and MBS collateralized debt obligations, and possibly other types of securities acquired to promote market stability.” Accordingly, even securities not directly linked to subprime mortgages may qualify as eligible troubled assets.
The term “residential” does not refer solely to single-family properties, because the Act requires the Secretary to consider purchasing real estate and securities relating to multifamily housing.
(2) Other Assets
Following consultation with the Federal Reserve System and notification to Congress, the Secretary also may purchase “any other financial instrument” as deemed necessary to promote financial stability.
Purchase Price for Troubled Assets
Purchases may be made directly (by negotiation) or through mechanisms such as reverse auctions, in which holders of comparable assets compete to sell those assets to TARP at the lowest price. Due to the difficulty of determining which real-estate based assets are “comparable” for reverse-auction purposes, we anticipate that as a practical matter TARP will rely initially and primarily on direct purchases.
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 an institution that is in conservatorship or receivership or has filed for Chapter 11 bankruptcy). 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 requirement described above may raise difficult valuation issues for the sellers and for TARP.
Conditions for Institutions Participating in TARP
Warrants and Debt Instruments
Under the Act, the Secretary may purchase, or make a commitment to purchase (whether in a direct purchase or an auction purchase), a troubled asset under TARP only if the Secretary receives the following from the selling financial institution:
The Secretary is required to establish de minimis exceptions making these provisions inapplicable if only a de minimis amount of troubled assets is sold to the Secretary. However, the de minimis threshold for a single institution must not exceed $100 million of troubled assets cumulatively sold to TARP during the duration of the program.
It is unclear what the impact would be of adding a new, “senior” debt instrument to the balance sheet of a troubled, private financial institution. It also remains to be seen how existing senior debt holders would react to such debt instruments.
A warrant or equity security must provide for “reasonable participation” by the Secretary in equity appreciation in the selling institution. Likewise, a debt instrument must provide a “reasonable interest rate premium.” Each warrant, equity security, or debt instrument also must provide additional protection for the taxpayer against (a) losses from the sale of assets by the Secretary, and (b) administrative expenses of TARP.
The requirements above are general in nature and remain to be clarified by forthcoming TARP policies and/or regulations. Among other things, it is unclear how the “additional protection” requirement will work, and whether there would be some type of ratchet provision if the Secretary resells troubled assets at a loss.
Other key aspects of the warrant and debt instrument provisions of the Act include the following:
Executive Compensation Limits
Institutions selling assets to TARP also will be subject to executive-compensation restrictions under the Act. The type of restrictions generally will depend on whether the assets are sold directly or through an auction process to the Secretary. The Act does not indicate why the two sale scenarios result in different rules, but one possibility is that in direct sales, TARP will have more flexibility to craft a buy-out package tailored to individual situations, while in auction sales, TARP can set more standardized criteria that apply to all participating institutions.
Direct Sales. If the Secretary receives a “meaningful” equity or debt position in a financial institution through direct (non-auction) purchases of assets, then the Secretary must require the financial institution to meet “appropriate standards” for executive compensation and corporate governance. The appropriate standards must include the following:
Auction Sales. For financial institutions that sell more than more than $300 million of assets to TARP using an auction process for at least some of the assets, the Secretary is required to prohibit any new employment agreements with senior executive officers of such institutions that provide a “golden parachute” in the event of involuntary termination, bankruptcy, insolvency, or receivership. The Secretary is required to issue guidance on this restriction by December 3, 2008.
For purposes of this restriction, a “senior executive officer” is any individual who is one of the top five most highly paid executives, as determined under the Securities and Exchange Act of 1934 proxy disclosure rules.
Tax Treatment of Executive Compensation
The Act also includes rules that modify the tax treatment of executive compensation paid by a participating institution. Generally, these provisions apply only if the institution (an “applicable employer”) is a member of a controlled group of corporations that sells (in the aggregate) more than $300 million of troubled assets to the Secretary (other than through direct sales).
Limits on Deductibility of Compensation. The Act amended Section 162(m) of the Internal Revenue Code (Section 162(m)) to disallow a deduction for annual compensation (including deferred compensation) in excess of $500,000 that is paid by an applicable employer to a “covered executive” in respect of services performed in any year during the term of the Act.
The Act applies the $500,000 limitation in a substantially different manner than the general $1 million limitation under Section 162(m). Ordinarily, the compensation deduction limitations of Section 162(m) apply only to publicly held corporations, do not apply to commission- or performance-based compensation (or to certain grandfathered compensation arrangements), and are calculated on the basis of total compensation paid during the year (other than excepted compensation) regardless of when the compensation was earned. By contrast, the $500,000 limitation added by the Act applies to both privately and publicly held corporations and permits no exception for commissions, performance-based compensation, or grandfathered compensation. In addition, the $500,000 limitation is calculated with respect to the year in which the compensation is earned and not the year it is paid. Thus, deferred compensation for services performed in a year covered by the Act may not be deducted when paid in a later year to the extent that it causes the total compensation for the services performed in the earlier year to exceed $500,000, but it will not affect the deductibility of compensation paid for services performed in the later year in which such deferred compensation is paid.
For purposes of the tax provisions of the Act, a “covered executive” includes the chief executive officer (CEO), chief financial officer (CFO), and any employee (other than the CEO and CFO) who is one of the three most highly paid executives (determined under the proxy disclosure rules, whether or not such rules apply) during any portion of a taxable year in which the Act is in effect.
Once an individual is determined to be a covered executive, he or she will remain a covered executive for the duration of TARP and afterward with respect to deferred compensation. Thus, an executive who is one of the three most highly paid executives in a year covered by the Act remains a covered executive in later years covered by the Act, even if he or she is not one of the three most highly paid executives in such years.
The Secretary is authorized to prescribe guidance, rules, or regulations necessary to carry out the purposes of these provisions, including to cover the case of any acquisition, merger, or reorganization of a participating employer.
Severance Payments. The Act also amends Section 280G of the Internal Revenue Code (Section 280G) to treat certain severance payments to covered executives as “parachute payments” even in the absence of a change of control. Under Section 280G, if the present value of such payments to a covered executive during the term of the Act equals or exceeds three times the executive’s average annual compensation during a prescribed base period, the excess of such payments over such average would be nondeductible to the employer and subject to a 20 percent excise tax to the employee under Section 4999 of the Internal Revenue Code.
This provision would apply only if the payment is made during the term of the Act as a result of the involuntary termination of the executive or in connection with any bankruptcy, liquidation, or receivership of the employer.
Market Transparency and Disclosure
To facilitate market transparency, the Act requires the Secretary to make publicly available (in electronic form, and within two business days of the transaction) the description, amount, and pricing of each purchase, trade, or other disposition. Given the unique nature of the assets, however, it will be difficult to use the disclosed information as a proxy for the valuation of other assets.
The Act also requires the Secretary to (a) determine whether each asset-selling institution has provided adequate public disclosure of its off-balance sheet transactions, derivative 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.” Thus, an institution participating in TARP may effectively subject itself to a “disclosure assessment.” It is unclear whether compliance with existing laws and accounting pronouncements would be sufficient or whether “adequate” disclosure suggests disclosures exceeding those standards.
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 percent of principal and interest payments. The total outstanding amounts of the guarantees will be counted toward the Secretary’s overall purchase authority under TARP, thereby reducing the total value of troubled assets that may be held by the Secretary at any one time.
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 expensive, and institutions holding troubled assets will want to weigh the premiums against the costs of selling troubled assets outright as well as the capital and liquidity implications of these alternative approaches. Because executive compensation is one of the costs to be weighed, institutions may want to involve independent advisors in making this determination to avoid conflict-of-interest issues.
Aid to Smaller Financial Institutions Affected by Fannie Mae and Freddie Mac
The Act does not list the preferred stock of Fannie Mae or Freddie Mac as being a qualifying asset, and recent Treasury releases confirm that such preferred stock is presently not considered a “troubled asset” for TARP purposes. However, reflecting congressional concern about the many smaller financial institutions that invested in the supposedly safe — but now devalued — preferred stock of Fannie/Freddie, the Act contains a number of provisions intended to aid these institutions.
First, the Act directs the Secretary to consider “providing financial assistance” to institutions that (i) have assets of less than $1 billion, (ii) were well-capitalized as of June 30, 2008, and (iii) dropped by one or more capital levels as a result of the Fannie/Freddie devaluation of preferred stock.
Non-Discrimination by TARP
Second, the Act requires the Secretary to ensure participation in TARP by financial institutions of all sizes, locations, and forms of organization, regardless of the size, types, or number of their assets eligible for purchase. (This requirement is not limited to institutions affected by the Fannie/Freddie devaluation.)
Tax Benefits for Sale of Fannie/Freddie Preferred Stock
Third, the Act provides a number of tax benefits to affected institutions, most of which have little in the way of capital gains against which to offset capital losses from the sale of Fannie/Freddie preferred stock.
The Act permits a bank, thrift, small business investment company, or other entity listed in Section 582(c)(2) of the Internal Revenue Code, or a depository institution under the Federal Deposit Insurance Act, to take the gain or loss from disposition of Fannie/Freddie preferred stock as an ordinary loss rather than a capital loss.
To qualify for ordinary-loss treatment:
In the case of Fannie/Freddie preferred stock that was acquired after September 6, 2008, the Secretary is authorized to extend this benefit (a) in a carryover basis transaction, or (b) to stock that was held indirectly by a partnership of which the financial institution is a member.
After the expiration of five years and the submission of a report on the net cost of TARP to the taxpayers, the Act requires the President to submit a legislative proposal to recoup from the financial industry any net losses. Only a legislative proposal is required, and not necessarily legislative action.
This provision refers to recoupment from the “financial industry,” which presumably includes all of the financial institutions authorized to sell assets to TARP. However, the provision’s scope is not limited to institutions that actually participate in the program.
In any event, it is too soon to forecast what legislative action, if any, would result from this provision.
While the Act provides that the Secretary may exercise “any rights received in connection with the troubled assets purchased,” it also specifies that the terms of any residential mortgage loan purchased by TARP shall “remain subject to all claims and defenses that would otherwise apply” — thus indicating that TARP does not have the authority to modify such residential mortgages without homeowner consent.
Meanwhile, the Act directs the Secretary to consent to reasonable requests for loss-mitigation measures, including term extensions, rate reductions, principal write-downs, increases in the proportion of loans allowed to be modified within a trust or other structure, or removal of other limitation on modifications.
The Secretary, and the various federal entities (the FDIC, the Federal Reserve, and the Federal Housing Finance Agency as conservator of Fannie Mae and Freddie Mac) that may become property managers in connection with mortgages purchased by TARP, are required to implement plans to maximize assistance for homeowners and encourage homeowners to take advantage of existing programs to minimize foreclosures. Among other tools, the Secretary is authorized to use loan guarantees and credit enhancements to facilitate loan modifications and prevent avoidable foreclosures.
Finally, the Secretary is directed to “encourage” both (a) the servicers of underlying mortgages to take advantage of the HOPE for Homeowners Program or other available programs to minimize foreclosures, and (b) the private sector to participate in troubled-asset purchases and investments in financial institutions.
Provisions Affecting All Depository Institutions
Commencement of Federal Reserve Payment of Interest on Required Reserves
The Act accelerates to October 1, 2008 (from October 1, 2011) the authority of the Federal Reserve to pay interest on the required reserve balances and excess balances maintained at the Federal Reserve by or on behalf of depository institutions.
Accordingly, and in order to help achieve its operating target for the federal funds rate set by the Federal Open Market Committee, the Federal Reserve issued a press release on October 6, 2008 announcing its intention, effective October 9, 2008, to amend Regulation D to require the Federal Reserve to pay interest equivalent to the average targeted federal funds rate less 10 basis points for required reserve balances, or less 75 basis points for excess balances.
Temporary Increase in Deposit Insurance
The Act temporarily increases the FDIC’s standard maximum deposit insurance amount (and the National Credit Union Administration’s standard maximum share insurance amount) from $100,000 to $250,000, through December 31, 2009. It is not known whether this increase will be made permanent.
The Act also establishes new prohibitions, subject to civil money penalties, on false advertising and misuse of FDIC names to (a) misrepresent any deposit liability, obligation, certificate, or share as being FDIC insured when such item is not FDIC insured, or (b) misrepresent the extent to which such item is FDIC insured.
Office of Financial Stability
TARP is to be managed by the newly created Office of Financial Stability (OFS). The Secretary has appointed Neel Kashkari, currently the Assistant Secretary of the Treasury for International Economics and Development, to head OFS on an interim basis, pending the nomination and Senate confirmation of a successor.
TARP operations may commence prior to the promulgation of regulations, and certain administrative and contracting requirements may be streamlined. However, within two days following the first purchase of troubled assets, the Secretary must publish program guidelines regarding criteria and methods for (a) selecting asset managers; (b) identifying troubled assets for purchase; and (c) pricing, valuing, and purchasing such assets. The first of these guidelines, regarding asset-manager selection procedures, was published on October 6, 2008.
The OFS is authorized to designate certain financial institutions as “financial agents” of the government and to “establish vehicles” for purchasing, holding, and selling troubled assets. A recent Treasury press release indicates that TARP may decide to engage in hedging activities to hedge portfolio risks.
In three RFPs published on October 6, 2008, the OFS solicited proposals from institutions to provide three types of core services: (1) lead custodian, (2) asset manager for mortgage-backed securities, and (3) asset manager for whole loans. The deadline for responding to these initial solicitations has passed, but the OFS indicates that in the future it will issue separate RFPs for “small and minority- and women-owned businesses” to be designated as sub-agents or sub-managers for the core institutions.
Oversight and Reports
The Act establishes three (possibly four) new government offices and agencies, identified below, to oversee the Secretary's administration of TARP. The Act also calls for several government studies. The purpose of the extensive oversight is to assure that taxpayer funds are spent prudently while the studies are meant to get at the root causes of the crisis with a view to enacting further legislation and revising the regulatory regime to prevent such a widespread financial calamity from happening again. Also, the studies are plainly intended to inform the oversight function.
Accordingly, Congress has created a “Financial Stability Oversight Board” (Board) to review the exercise of authority under the Act, making recommendations to the Secretary as to the use of its authority and reporting any suspected fraud, misrepresentation, or malfeasance to other authorities. Members of this Board, which will meet monthly, are the Chairman of the Federal Reserve Board, the Treasury Secretary, the Chairman of the Securities and Exchange Commission (SEC), and the Secretary of the U.S. Department of Housing and Urban Development. The Board may appoint a “Credit Review Committee” to evaluate the exercise of the purchase authority granted by the Act and the assets acquired by the government. The Board is to report semiannually to the appropriate committees of Congress and to the “Congressional Oversight Panel” also created by the Act.
Shortly after adoption of the Act, the Secretary is directed to report to the appropriate committees regarding actions it has taken and expenditures of funds. Subsequently, after each $50 billion of utilization, the Secretary is to report to the appropriate committees how the money has been used, including a description of the pricing mechanism, justification of the financial terms, and a description of the impact on the financial system. There will be monthly reports to Congress on the number and types of loan modifications and the number of foreclosures occurring. Congress can block the expenditure of the second of two $350 billion segments of the program by timely adopting a joint resolution of disapproval.
Under the Act, the Comptroller General of the U.S. Government Accountability Office (Comptroller General) is expected to oversee TARP in all respects. This is extremely broad coverage. The Treasury must literally make room for the Comptroller General and provide full access to the Treasury’s records and the records of agents and representatives of TARP. The Comptroller General is to report every 60 days to the appropriate committees of Congress and to the “Special Inspector General for the TARP.” TARP will prepare annual financial statements in accordance with GAAP, which the Comptroller General will audit in accordance with GAAS. The Comptroller General also can audit agents and representatives of TARP. TARP will remedy deficiencies arising upon audit and will establish and maintain internal controls.
The Special Inspector General for the TARP mentioned above will audit and investigate asset purchase and insurance programs and management of same by the Secretary. Inquiries will cover matters such as: what assets are being purchased, why, from whom, detailed biographical information on persons hired to manage same, accounting for profit and loss upon resale, and identification of insurance contracts issued under the Act. The Special Inspector General for the TARP is to furnish quarterly reports to the appropriate committees.
The Congressional Oversight Panel also mentioned above will review the current state of the financial markets and the financial regulatory system and submit reports to Congress. Monthly reports will cover topics such as use of authority by the Secretary under the Act, impact on markets and institutions of purchases made under the Act, the extent to which transaction information made available has contributed to market transparency, the effectiveness of foreclosure mitigation efforts, and minimization of costs to taxpayers. A “Special Report on Regulatory Reform” is due on January 29, 2009. This panel will have five members, appointed by U.S. House and Senate leadership.
The Act requires three government studies in addition to the special report on regulatory reform already noted. One is a “Regulatory Modernization Report” to be delivered to the appropriate committees (and shared with the Congressional Oversight Panel) by the Secretary no later than April 30, 2009. This report must analyze the current state of the financial regulatory system and its effectiveness, with particular attention paid to over-the-counter (OTC) swaps and Government Sponsored Enterprises (GSEs), and make recommendations for improvements. This report will be shared with the Congressional Oversight Panel.
Next is a report on margin authority, meaning the use of leverage in the financial markets. By June 1, 2009, the Comptroller General is to study and report on how leverage and sudden deleveraging of financial institutions might have contributed to the credit crisis, including discussion of the roles and duties of the SEC and other federal regulatory agencies relative to these occurrences and recommendations for improvement.
Also, the SEC is to study mark-to-market accounting in consultation with the Board and the Secretary, considering the effects of such accounting on financial institution balance sheets, the impact on bank failures in 2008 and the advisability of modifying the standards. This report is to be delivered to Congress in early January 2009.
The SEC also was given authority in the Act to suspend mark-to-market accounting for any issuer or with respect to any class or category of transaction if it finds that action to be in the public interest and consistent with the protection of investors. In this connection, the SEC Office of the Chief Accountant and Financial Accounting Standards Board staff jointly issued a statement on September 30, 2008 purporting to “clarify” the application of fair value measurement standards. We have reported on that development separately and will continue to follow the issue. (See SEC and FASB Jointly Address Fair Value Accounting Legal News Alert: Financial Crisis Response Team at http://www.foley.com/publications/pub_detail.aspx?pubid=5346)
TARP will continue to evolve on a near-daily basis for the foreseeable future. Foley will continue to monitor TARP and the development and implementation of its policies, procedures, and regulations.
If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or:
Joshua A. Agen
Steven R. Barth
Theodore H. Bornstein
Patrick D. Daugherty
Philip G. Kiko
Patricia J. Lane
John B. Palmer III
John L. Rogers III
Jay O. Rothman
George T. Simon
Stephen B. Waller