Ten days after Secretary of the Treasury Paulson first went to Capitol Hill seeking broad authority to spend up to $700 billion to purchase mortgagebacked securities and other assets from a wide variety of financial institutions, a tentative compromise deal has been reached between the Administration and the Congressional leadership.1 Treasury’s original three-page proposal had morphed into a 110-page piece of legislation with a myriad of new provisions providing oversight, restricting Treasury’s authority, limiting executive compensation, altering the tax code, providing a mechanism for the government to recoup any losses, and providing for foreclosure mitigation. How much of that lends clarity, and how much further confusion?2
The bill is now titled the Emergency Economic Stabilization Act of 2008 (EESA). It retains the same basic underlying structure of the original Treasury Proposal, a good-bank/bad-bank formula in which the various financial institutions will all get to be the good banks and the federal government will create a giant bad bank to hold various problematic assets. The hope is that this strategy will both provide needed relief to struggling financial institutions to get back on their feet, and also allow the market for the currently problematic assets to reset, eventually enabling the government to sell those assets without loss, and maybe even at a profit.
The current version of EESA makes important changes from the early version of the bill to the definitions of Financial Institution3 and Troubled Assets.4 There is one seemingly minor change to the definition of Financial Institution that may make a significant difference in who is able to sell assets to the Treasury under the program—a comma after the list of included institutions. The inclusion of this comma makes it clear that the later phrases “organized and regulated” and “having significant operations in the United States” relate to all of the included institutions. What is still unclear, however, is who exactly is included in the definition of a Financial Institution. The definition is drafted so broadly, that it appears that any institution can be a Financial Institution. The list of types of institutions is written as a list of examples, and not a limitation, due to the fact that it is preceeded by the phrase "including but not limited to". Thus, although hedge funds and REITs, for example, are not included in the list of examples, the Secretary could interpret the term to include them as Financial Institutions.
In addition, although not included in the definition of a Financial Institution (and thus not subject to the executive compensation limits and other requirements of participation in the program), if foreign financial authorities or central banks hold troubled assets as a result of extending financing to financial institutions that have failed or that defaulted on such financing, the authorities’ or banks’ assets qualify for purchase
as troubled assets.5 There is also a change in the definition of Troubled Assets. Under the Treasury Proposal and the House version of TARA, to be included in the definition, the assets had to have been originated or issued prior to September 17, 2008. Under EESA, the date is moved back to March 14, 2008, limiting the pool of assets that may be sold by the included institutions.
One of the major differences between EESA and all of the previous proposals is that it puts tighter limits on the amount of money Treasury can spend. EESA initially gives the Secretary the authority to have up to $250 billion outstanding at any one time.6 An additional $100 billion of authority is granted upon written certification of need by the President.7 Thereafter, an additional $350 billion may be authorized if the President provides Congress with a written report detailing the Secretary’s plan for spending the money.8 If the President provides such a report, the additional money is authorized unless Congress issues a joint resolution disapproving of the additional authorization within 15 calendar days.9 Such a resolution must be introduced no later than three calendar days after the President’s report is received by Congress and must follow a prescribed format.10
In addition to sales of assets, EESA requires an alternative mechanism. In order for the Secretary to exercise any authority at all under the bill, the Secretary must first establish an insurance program to guarantee a Financial Institution’s assets. The insurance premiums will be risk-based and the aggregate amounts guaranteed will be deducted from the aggregate amount the Secretary is authorized to purchase.11
The Secretary’s authority to purchase assets and provide insurance terminates on December 31, 2009, unless he submits a written certification to Congress of the need to extend his authority “to assist American families and stabilize the financial markets” along with the expected costs for such an extension. However, in no event can his authority be extended beyond two years from the date of enactment of the legislation.12
As with all previous proposals, the national debt limit is increased from $8,184,000,000,000 to $11,315,000,000,000 to allow for all of this authority.13
EESA requires the establishment, within Treasury, of an Office of Financial Stability within the Office of Domestic Finance, to implement the program headed by an Assistant Secretary.14 EESA also requires the Secretary to publish guidelines for the program, including (1) mechanisms for purchasing troubled assets, methods for pricing and valuing troubled assets, procedures for selecting assets managers and criteria for identifying troubled assets.15 These guidelines must be published quickly: specifically, before the earlier of 2 business days after the first purchase of assets under the program or 45 days after the enactment of the legislation.16
As with earlier Congressional discussion drafts, under EESA the Secretary must consult with various organizations when exercising authority under the legislation.17 And as was the case with earlier discussion drafts, EESA fails to provide any indication regarding what it means to “consult” in this context. EESA also expands the list of things the Secretary must consider when exercising authority under the legislation.
The Treasury Proposal required the Secretary to take into consideration means for providing stability and preventing disruption to the financial markets and banking system, and protecting the taxpayers. The House version added that the Secretary must take into consideration the strength of any financial institution from which he is considering purchasing assets. In our earlier Client Alert on the House version of TARA, we questioned whether that requirement meant that institutions must be otherwise financial sound enough so that the purchase will be sufficient to ensure their survival, or did it mean that generally sound institutions that are likely to survive without a government purchase of their assets will not be part of the plan. EESA appears to answer that it should be the former, by rewording this requirement to read that the Secretary must consider “the long-term viability of the financial institution in determining whether the purchase represents the most efficient use of funds under the Act.”18 EESA also includes several additional considerations that first appeared in Senator Dodd’s September 25, 2008 discussion draft (Dodd’s Draft):
- the need to help families to keep their homes and stabilize their communities;
- ensuring that as many financial institutions as possible participate in the program regardless of size;
- including financial institutions serving underserved communities, that have assets of less than $1 billion and were adequately capitalized as of June 30, 2008, and that, as a result of the devaluation of the GSEs stock, will drop one or more capital levels, in a manner sufficient to restore the financial institutions to at least an adequately capitalized level;
- the need to ensure stability for United States public instrumentalities;
- the ability of the Secretary to purchase assets held on behalf of a 401(k), pension or other retirement plan; and
- the utility of purchasing other real estate owned and instruments backed by mortgages on multi-family properties.19
Limiting Wall Street Profits
A new provision found in EESA is a requirement to prevent unjust enrichment.20 The Secretary must take such steps as may be necessary to prevent unjust enrichment of selling financial institutions, including by preventing the sale of troubled assets to the Secretary at a higher price than what the seller paid to purchase the asset.21
EESA also imposes limits on the executive compensation of any financial institution that chooses to sell assets to Treasury under the legislation. In the case of a direct sale of assets, where “the Secretary receives a meaningful22 equity or debt position in the financial institution,”23 the financial institution must agree to:
(A) limits on compensation that exclude incentives for executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution; (B) a provision for the recovery by the financial 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; and (C) a prohibition on the financial institution making any golden parachute payment to its senior executive officer during the period that the Secretary holds an equity or debt position in the financial institution.24
In the case of auction purchases, where such purchases from any one financial institution exceed $300 million in the aggregate, including direct purchases, new employment contracts with senior executive officers may not contain golden parachutes.25
One interesting aspect of the executive compensation provision is that, in many instances, the financial institution selling the assets to the Treasury will be a non-public subsidiary, and the limits on executive compensation appear to only reach the regulated seller, not its parent or holding company.
EESA retains the modest foreclosure mitigation provisions originally introduced in the House version of TARA. Specifically, the Secretary is required to (1) “encourage” the servicers of the mortgages underlying the Troubled Assets to take advantage of the Hope for Homeowners Program that was recently enacted under the Housing and Economic Recovery Act of 2008, (2) as an investor, consent to all reasonable loan modification requests, and (3) request that loan servicers of the mortgages underlying the Troubled Assets avoid preventable foreclosures.26 Similar requirements are imposed on other federal agencies holding mortgages, mortgage-backed securities and other assets secured by residential real estate.27
Protection for Taxpayers
In an attempt to minimize the cost of the bill, in a nod to the obvious, the Secretary is directed to maximize the value for taxpayers when determining whether and when to sell the assets he buys, purchase assets at the lowest price consistent with the purposes of the bill and to use both market mechanisms and direct purchases where appropriate.28
Some of the original proposals were unclear as to the use of warrants under the bill. EESA makes them a requirement. For sellers with registered and exchange-traded stock, warrants for non-voting common stock or preferred stock (as determined by the Secretary) are required for participation in the program. For all other companies, senior debt instruments must be given.29 This raises the question of how the sellers’ balance sheets will be affected by a decision to participate in the program.
The false advertising provisions of the Federal Deposit Insurance Act are enhanced and the FDIC is permitted to take action against any offending institution if its primary federal supervisor fails to do so.30
EESA requires the Secretary to reimburse the Exchange Stabilization Fund for funds used to temporarily guarantee the money market mutual fund industry. The Secretary is prohibited from using the Exchange
Stabilization Fund for any such future programs.31
The Securities and Exchange Commission is given the authority to suspend mark-to-market accounting32 and is tasked with producing a study, in consultation with the Secretary and the Board of Governors of the Federal Reserve System, on mark-to-market accounting. The report on the study is to be submitted to Congress within 90 days of the enactment of the legislation.33
Finally, a provision was added at the last minute that requires the President to submit a proposal to Congress to recoup from the financial services industry any losses incurred by the program after five years.34 No details are provided on what such a proposal might entail, although taxes or fees seem to be what is meant.
The House version of TARA established a Congressional Oversight Panel (Oversight Panel). EESA keeps the Oversight Panel but makes some changes. The House version required annual reports, whereas the EESA version requires reports every 30 days35 and an additional report, no later than January 20, 2009, on the state of the regulatory system and the possible need for reform.36 The EESA version of the Oversight Panel is tasked with reviewing and reporting on not just the Secretary’s use of authority under the legislation (specifically, administration of the program, contracting under the program, the impact of purchases of Troubled Assets on the financial markets and financial institutions, market transparency and the effectiveness of the legislation’s foreclosure mitigation provisions),37 but also “the current state of the financial markets and the regulatory system.”38 As with earlier versions, in order to carry out these duties, the Oversight Panel would have the power to hold hearings, take testimony, and receive evidence, and obtain official data from any department or agency of the United States.39 There would be five members of the Oversight Panel, one each appointed by the Speaker of the House, the Minority Leader of the House, the Majority Leader of the Senate, the Minority Leader of the Senate and a final member appointed by all four of the above leaders.40 The members would receive a salary unless they are already federal employees or members of Congress41 and would also have the ability to hire a staff, experts, and consultants and “borrow” personnel from federal departments and agencies.42
EESA also keeps the Financial Stability Oversight Board (Oversight Board) first proposed in Dodd’s Draft, with some revisions. The duties of the Oversight Board would be to review all policies implemented by the Secretary and the Office of Financial Stability under the legislation, and their effects, and to make recommendations and report fraud, misrepresentation and malfeasance.43 The Oversight Board appears to have some real power, in that it would be authorized to ensure that the policies implemented by the Secretary are in accordance with the purposes of the Act, in the economic interests of the United States, and consistent with protecting the taxpayers.44 It would be comprised of the Chairman of the Board of Governors of the Federal Reserve System, the Secretary, the Director of the Federal Home Finance Agency, the Chairman of the Securities and Exchange Commission, and the Secretary of Housing and Urban Develop-ment.45 To assist them in their duties, they could appoint a credit review committee.46 The Oversight Board is required to report to various Congressional committees and the Oversight Panel semiannually.47
EESA also expands the Secretary’s reporting requirements.48 Within 60 days of the first purchase of assets or sale of insurance under the program and every 30 days thereafter, the Secretary is required to report to various Congressional committees by providing an overview of his actions under the legislation and stating actual obligations and expenditures of funds for the period, and expected expenditures of funds for the next period.49 In addition, he must provide a detailed financial statement of his exercise of authority under the legislation.50 He must also provide an additional written report within seven days of each expenditure of an aggregate of $50 billion.51
One final, but potentially extremely important report required by EESA is the Regulatory Modernization Report that the Secretary is required to present to various Congressional committees by April 30, 2009. This report goes to the issue of the underlying causes of the current situation and has the potential to shape the course of this country’s future finance regulation. The Secretary is charged with analyzing the state of the regulatory system and providing recommendations for improving the system.52
In addition, there are detailed provisions for oversight and audits of the program by the Comptroller General, as has been required in every discussion draft generated by Congress.53 The Comptroller General is also directed to undertake a study to determine the extent to which leveraging of financial institutions and use of margin authority by the Board of Governors of the Federal Reserve System was a factor in creating the current economic situation, and issue a report no later than June 1, 2009.54 A Special Inspector General would also be appointed to oversee the program.55
Finally, the actions of the Secretary under the legislation are subject to judicial review. This represents a departure from all previous versions of the bill. EESA provides that actions by the Secretary under the legislation are subject to the provisions of federal law providing for judicial review of actions by federal agencies.56 Courts are, however, limited in their ability to provide equitable relief when an action relates to the Secretary’s actions in purchasing assets, providing insurance, managing and selling assets, or with regard to foreclosure mitigation procedures, with equitable relief only being allowed in such circumstances to remedy a violation of the Constitution.57
EESA contains three tax provisions. The first tax provision is intended to lessen the tax burden of troubled banks and financial institutions, the second is intended to limit compensation to certain senior executives, and the final tax provision is intended to limit the tax burden of taxpayers who will be modifying the indebtedness on their primary residence.
First, EESA allows the gain or loss from a sale or exchange of preferred stock in Fannie Mae or Freddie Mac held by certain banks and other financial institutions to be treated as ordinary income or loss for tax purposes.58 This provision allows these banks and financial institutions to take such losses, which would otherwise be treated as capital losses, against their ordinary income. This provision applies to any preferred stock held on September 6, 2008 or sold or exchanged by such a bank or financial institution between January 1, 2008 and September 6, 2008.59
Second, EESA would limit the tax deduction for executive compensation for any company for which the Treasury Department has purchased one or more assets under this legislation totaling an aggregate of $300 million (not counting assets acquired through one or more direct purchases).60 Once the $300 million threshold is met, the company’s compensation deduction will be capped at $500,000 per year for each of the company’s “covered executives,” i.e., the CEO, CFO and the three other highest compensated employees of the company.61 Unlike the current $1,000,000 deduction limitation for remuneration paid to covered employees, there would no exceptions to the $500,000 deduction limitation for a covered executive’s commission-based or performance-based compensation. The $500,000 deduction limitation would also apply to any deferred compensation applicable to services performed by the covered executive after the threshold is met, but not with respect to services performed in a prior tax year.62 In addition, existing golden parachute rules are extended to prohibit a deduction for severance paid to any covered executive in connection with an involuntary termination of employment or any bankruptcy, liquidation or receivership of the company.63
Finally, EESA would extend from 2009 through 2012 the relief from cancellation of indebtedness forgiveness for homeowners, which was originally enacted in the Mortgage Forgiveness Debt Relief Act of 2007 (P.L. 110-142).64