On October 3, 2008, after a turbulent two and half week controversial congressional journey, the President signed the Emergency Economic Stabilization Act of 2008 (“Act”). Starting as a threepage document that provided unfettered authority to the Secretary of the Treasury (“Secretary”), the Act now provides extensive requirements on the conduct of the Department of the Treasury’s (“Treasury”) troubled asset purchase activities, as well as oversight, transparency, and appropriation controls. The following discussion does not address all aspects of the Act. It instead focuses on the financial stabilization provisions of the Act.
The Act seeks to achieve four key objectives.
- Remove troubled mortgage and mortgage-related assets from the books of a broad range of financial institutions by transferring them to the US Treasury.
- Avoid foreclosures by making it easier for borrowers under stress to meet their mortgage obligations.
- Impose a toll on financial institutions that need to participate in the program through executive compensation limitations and equity or debt compensation to the Treasury.
- Protect the taxpayers from ultimately taking losses from the program.
The Act leaves open the most important question that will determine its impact – at what price will the Treasury buy troubled assets? The answer to this question will obviously be an important factor in determining the willingness of financial institutions to participate in the program. Even for those institutions that do not participate in the program, the high visibility that will be given to the Treasury’s purchase prices, whether in auction formats or direct purchases, has the potential to have a significant impact on the valuation of mortgage assets in the country.
The Treasury is now faced with a difficult task. If it were to attempt to purchase at prices that reflect “current” values in a highly illiquid market, it may not attract the volume of sales that are necessary to achieve the goal of relieving financial institutions of the burden of carrying troubled assets. On the other hand, purchases at prices that are significantly more attractive to sellers than market prices run the risk of being labeled a taxpayer giveaway, could be a viewed as favoritism to those selected for such purchases, and could artificially inflate the values of certain asset categories in a manner that prolongs the period needed to adjust the economy to the actual new values for housing assets.
Key points for potential sellers.
Broad range of potential sellers. The Act could be interpreted to permit the Treasury to purchase assets from an extremely wide range of entities that might qualify as a financial institution. At a minimum, eligible sellers are depository institutions, brokers and dealers and insurance companies that are established and regulated under US laws and that have significant operations in the US. The Act could, however, be read to permit purchases from the full range of domestic and foreign entities that could be considered to be financial institutions. The Act does exclude foreign central banks or institutions owned by a foreign government, although purchases from foreign central banks are permitted in limited circumstances. Treasury presumably will interpret the breadth and scope of financial institutions that are eligible to participate in the program when it promulgates its program guidelines.
Broad range of potential assets eligible for purchase. At a minimum, the Treasury is authorized to purchase residential or commercial mortgages, and securities related to such mortgages, that were originated or issued on or before March 14, 2008. The Treasury, after consultation with the Chairman of the Federal Reserve Board, may purchase any other type of financial instrument if the Secretary determines that the purchase is necessary to promote financial market stability, subject to notification to the Congress.
General Principles Governing Treasury Purchases. The Act sets forth a number of principles to guide the Treasury’s purchase activities under the Troubled Asset Relief Program (“TARP”).
“Lowest” Price – A Flexible Concept. Most significantly, the Treasury is to make purchases at the lowest price that the Secretary determines to be consistent with the purposes of the Act. As a practical matter, this gives great flexibility to the Secretary, since he may determine that prices above the lowest level that could be achieved are appropriate to effectuate the Act’s intent of stabilizing the financial system. The Treasury is directed to take steps to prevent unjust enrichment of institutions, including generally prohibiting the sale of a troubled asset to the Treasury at a higher price than the seller paid to purchase the asset. This latter limitation impacts the ability of a party to purchase troubled assets for resale to the Treasury.
Market Mechanisms Are Favored, but Direct Purchases are Permitted. The Act establishes a preference for the use of market pricing mechanisms, including auctions and reverse auctions (“Auction Purchases”). It provides, however, that if the Secretary determines that the use of a market mechanism is not feasible or appropriate, and the purposes of the Act are best met through direct purchases from an individual financial institution, the Secretary may engage in direct purchases (“Direct Purchases”). In that event, the Treasury must pursue additional measures to ensure that prices for assets are reasonable and reflect the underlying value of the assets.
Program Guidelines Must Be Published. The Treasury is required to publish program guidelines that address, among other things, (i) mechanisms for purchasing troubled assets, (ii) methods for pricing and valuing troubled assets, (iii) procedures for selecting asset managers, and (iv) criteria for identifying troubled assets for purchase, before the earlier of the end of the two-business-day period beginning (x) on the date of the first purchase of troubled assets or (y) the end of the period beginning on the end of the 45-day period beginning on enactment of the Act.
Requirement to Obtain Warrants, Equity Securities or Debt Securities as a Condition of Purchases. Subject to a minimum threshold requirement for both Auction Purchases and Direct Purchases, the Act requires the Treasury to receive, in the case of a financial institution that has securities traded on a national securities exchange, warrants for nonvoting common stock, preferred stock, or voting common stock in the financial institution. The Secretary must agree not to exercise voting power in the case of such voting power.
In many instances, bank securities are not traded on a national securities exchange; the securities of the bank’s holding company are usually subject to such trading. If a financial institution does not have securities traded on a national securities exchange, the Treasury must receive a warrant for common or preferred stock or a senior debt instrument of the financial institution. This provision does not require that the Treasury be barred from voting such common stock.
The Act does not establish any specific basis for determining the amount of underlying stock that the Treasury must receive in a transaction or the exercise price of any warrants acquired. The warrant or equity security must provide for equity participation or a reasonable interest rate premium in the case of a debt instrument, and it must provide for additional protection against losses from the sale of the assets acquired. The Secretary is authorized in his discretion to determine the strike price for the warrant.
The Act permits the Treasury to establish an exception from these requirements for aggregate purchases under the program that may not exceed $100 million per institution.
Executive Compensation and Corporate Governance Standards Applicable to Direct Purchases. Certain executive compensation limits and corporate governance standards may be imposed on institutions that engage in Direct Purchase transactions. Where the Secretary determines the purposes of the Act are best met by a Direct Purchase, where no bidding process or market prices are available, and the Treasury receives a “meaningful” equity or debt position in the institution as a result of the Direct Purchase, the Secretary shall require the institution to meet appropriate standards for executive compensation and corporate governance (“Direct Purchase Standards”). The Act does not give any indication as to what would be considered to be a “meaningful” equity or debt position.
The Act specifies that the Direct Purchase Standards to be established by the Treasury shall include:
- Limits on compensation for persons who qualify as senior executive officers of a financial institution that exclude incentives to take unnecessary and excessive risks during the period that the Treasury holds an equity or debt position in the institution. The Treasury will have to establish the standards to make this a workable formula.
- A provision for recovery by the institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate. The Act does not address the question of whether an individual who did not contribute to such inaccuracy would be subject to the recovery.
- A prohibition on the institution making any golden parachute payment to a senior executive officer during the period that the Treasury holds an equity or debt position in the institution. While the Act specifies certain required executive compensation principles, it does not address any corporate governance standards that the Treasury must issue. It remains to be seen what action, if any, the Treasury will take in this regard.
Under the Act, a “senior executive officer” is an individual who is one of the top five highly paid executives of a public company, whose compensation is required to be disclosed pursuant to the Securities Exchange Act, and Securities and Exchange Commission regulations thereunder, and non-public counterparts.
Any financial institution that becomes subject to the Direct Purchase Standards imposed by the Treasury will remain subject to Direct Purchase Standards as long as the Treasury continues to hold an equity or debt position in the financial institution.
More Limited Requirement Imposed on Auction Purchase Participants. An institution that engages in Auction Purchases, but that does not engage in Direct Purchases, will not be subject to any of the Direct Purchase Standards that might be applicable to a particular institution that engages in Direct Purchases.
The Act imposes only one executive compensation restriction on an institution that sells assets exclusively in Auction Purchases. Any institution that participates in Auction Purchases that exceed $300 million (which include the value of any Direct Purchases) is prohibited from entering into a new employment contract with a senior executive officer that provides a golden parachute payment in the event of an involuntary termination, bankruptcy filing, insolvency, or receivership. The foregoing restriction only applies during the period in which the Treasury is authorized to make purchases of troubled assets, which will conclude on December 31, 2009, unless extended by the Secretary as permitted under the Act.
Limitations on Deduction of Covered Executive Compensation. The Act provides that an applicable employer (as defined below) may not take a deduction for compensation paid to a covered executive (as defined below) in any applicable taxable year that exceeds $500,000. An applicable employer is an employer from whom troubled assets are acquired by the Treasury in an amount over all taxable years that exceeds $300 million. Interestingly, this calculation does not include the amount of Direct Purchases, if such purchases were the only purchases made by the Treasury under the program. A covered executive is defined to include (i) any chief executive officer or chief financial officer during any applicable portion of an applicable tax year and (ii) the three highest compensated officers for the taxable year who are employed during the applicable portion of an applicable taxable year. It is not clear why the Act treats Auction Purchases more favorably than Direct Purchases for purposes of other executive compensation provisions, but less favorably in this regard.
Disclosure of Purchase and Sale Transactions. The Treasury will be required to disclose a description of the type of assets, amounts and prices within two business days of any purchase or sale.
Insurance of Troubled Assets. The Act also offers financial institutions the option of obtaining guarantees for troubled assets from the Treasury. The Treasury is authorized to guarantee timely payment of principal and interest on troubled assets not to exceed of 100% of such payments. Institutions participating in this program will be charged premiums determined by the Treasury.
The Treasury is authorized to hire contractors to assist it in carrying out the Act.
The Act permits the Treasury to waive specific provisions of the Federal Acquisition Regulation (“FAR”) if it makes a determination that urgent and compelling circumstances make compliance with such provisions contrary to the public interest. The Treasury is also directed to consider the Federal Deposit Insurance Corporation (“FDIC”) in its selection of asset managers. If the Treasury waives FAR minority contracting provisions, Treasury is required to implement procedures to ensure, to the maximum extent possible, the inclusion and utilization of minorityand women-owned businesses in contracting for asset managers, servicers, property managers, and other service providers or expert consultants.
The Act requires the Treasury to issue regulations or guidelines to address or prohibit conflicts of interest. These include conflicts relating to:
- The selection or hiring of contractors or advisors;
- The purchase of troubled assets; and
- The management of troubled assets.
It remains to be seen to what extent the Treasury will rely on its own contractors or will utilize the resources of the FDIC. It seems likely that the Treasury will want to utilize private sector financial experts in the difficult areas of valuing assets and developing purchase and disposition methodologies. The Treasury’s need for asset managers may vary depending on the extent to which purchases are allocated between mortgage loans and mortgage related securities. In the latter case, it seems likely that the Treasury would rely on the existing servicing structure associated with the particular mortgage-backed security.
Parties interested in becoming contractors for the TARP should recognize that a special set of requirements and principles apply to contractors for the federal government. Depending on how the Treasury handles this particular process, government contract principles may raise issues for contractors ranging from eligibility requirements, bid protests, contractor conduct requirements, and payment disputes.
The Act gives the Treasury broad authority to manage the troubled assets that it acquires, including holding assets to maturity or disposing of them in a manner determined by the Treasury. It remains to be seen whether the Treasury will in the near term explore the possibility of disposing of certain of the troubled assets that it acquires, or whether it will prefer to hold assets awaiting a recovery in the relevant asset categories. Guidelines are sure to be issued with regard to the processes that will be put in place to dispose of assets purchased by the Treasury.